Reality Based Real Estate Investing| Minnesota Homes For Sale

“Reality Based” Real Estate Investing

©2007-08 John Mazzara

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http://www.RealityBasedRealEstateInvesting.com

“Reality Based” Real Estate Investing ALL RIGHTS RESERVED No part of this publication may be reproduced, changed, altered, stored in a retrieval system or freely transmitted in any form or by any means mechanical, photocopying, recording, or otherwise, without written permission of the copyright holders. Any unauthorized use of this material is prohibited. Authored & Published by: John Mazzara RE/MAX Associates Plus 7450 France Ave S Suite 100 Edina, MN 55436 952-929-2577 Office 612-386-7027 Cell 952-928-3799 Fax [email protected] http://www.RealityBasedRealEstateInvesting.com DISCLAIMER AND/OR LEGAL NOTICES-READ THIS FIRST The information presented herein represents the views and opinions of the author as of the date of the publication. Because of the rate with which conditions in the market change, the author reserves the right to alter and update his opinion based on new conditions as they may present themselves in the future. This publication is for entertainment and informational purposes only. This publication is not intended for use as a source of legal, accounting, or financial advice. While all attempts have been made to verify information provided, the author/publisher assumes no responsibility for errors, omissions, or contrary interpretation of the subject matter herein. The author/publisher wants to stress that the information contained herein may be subject to varying federal, state and/or local laws and ordinances. All users are hereby advised to retain competent advisors to determine what state and/or local laws or regulations may apply to the user’s particular situation or application of this information as it might pertain to their circumstances. As such, the purchaser or reader assumes complete and total responsibility for the use of these materials and information. The author/publisher does not guarantee any results-implicit or otherwise-that you may or may not experience as a result of following the recommendations or suggestions contained herein. Investing in real estate is not for everyone. Investing in real estate involves risk with no guarantee of any return. You can lose money. Invest in real estate at your own peril. Any perceived slights of specific people or organizations are unintentional. COPYRIGHT Copyright Notice © 2007-2008 John Mazzara


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“Reality Based” Real Estate Investing CONTENTS Prologue

Why Should YOU Invest Your Time Reading This Book? 4

Chapter 1

Setting Your Goals & Reality Check

Chapter 2

Optimal Property Selection-You Have MANY CHOICES 15

Chapter 3

Geographic & Demographic Considerations Who, Where & Why!

49

Chapter 4

Correct Investment Property Financing

55

Chapter 5

Holding Period Considerations For Maximum Benefit

67

Chapter 6

Tax Benefits of Real Estate Ownership

75

Chapter 7

1031 ExchangeThe Key To Massive Wealth Accumulation

79

Chapter 8

Lease Considerations-Clauses & Concerns

83

Chapter 9

Title-How You Want To Own Your Real Estate

89

Chapter 10

Insurance-Neglect This Area At Your Own Peril

91

Chapter 11

Putting It All Together-The Next Steps

94

Epilogue

Closing Thoughts & My Proposition To You

96

APPENDIX

Goal Setting Questions & Required Exercise

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SHHH-NOT SO LOUD! KEEP YOUR ENTHUSIASM TO YOURSELF! LISTEN, IF THESE SECRETS ARE MADE PUBLIC, INVESTORS EVERYWHERE WILL BE EMPOWERED. WITH THIS BOOK, YOU HOLD THE KEYS TO HAVING AN UNFAIR ADVANTAGE. ENJOY THESE TRUE CONFESSIONS AS I SHARE TWENTY-THREE YEARS OF SUCCESSFUL REAL ESTATE INVESTING STORIES, TIPS AND ADVICE. Seriously, thanks for picking up this book. You now hold “a world of real estate knowledge” in the palm of your hands. I know you will find it useful whether you are a newbie or a seasoned professional. If I can help you in your real estate endeavors, just call or drop me an email. My contact information can be found on my website at http://www.johnmazzara.com . A wealth of real estate information is available to you at my real estate website http://www.selling.mn. Please note: this ends in .mn

SIX QUESTIONS YOU MUST ASK BEFORE STARTING THIS BOOK

#1 Q) WHY SHOULD YOU INVEST YOUR TIME IN READING THIS BOOK? A) I have been in this industry a long time. My experience will shorten your learning curve and you will be the beneficiary of my success and failures. There is an old cliché’ “knowledge is power.” I would like to recast the adage to read this way: the application of knowledge is power. Regarding real estate investing, I’ve “been there-done that”. I’ve been successfully selling homes and investing in real estate since 1986. In 2007 I was named as a “Super Agent” by Mpls St Paul Magazine. Only 4% of the licensed agents within Minnesota received the 2007 award of Super Real Estate Agent, and I was one of those agents! When I speak about investing in real estate, I want you to understand that I speak from actual experience, NOT theory. You will gain 23 years of my experience when you read this book. You will learn about my successes and failures. I will also give you some specific ideas on where I see opportunities for investing in real estate today. My goal in writing this book is to convey my knowledge to you in a concise and informal manner so that you can use it to achieve your financial goals. Financial freedom has been achieved for many people through ownership of real estate. Will you be the next real estate mogul? After reading this book and investigating real estate investing further, you might find that you don’t want to become a real estate investor. Reading this book gives you the knowledge you need to decide if real estate is right for you. If you do decide to pursue owning investment real estate after reading this book, you will make better decisions because you will be better informed. Your price of admission to my Real Estate University is the cost of this book and your time invested in reading it. Other than the


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“Reality Based” Real Estate Investing use of my professional services provided by me and affiliated companies, I have nothing else to sell you. There are no follow-on books or tapes. I do offer a more personalized one on one program to help you write, define, and execute your goals. There is a cost involved with this program and participation is optional. If I demonstrate to you that I can add value to your life, consider adding me to your team of advisors. There is a lot of information here, so take your time and digest the material. Don’t be an uninformed investor. Don’t repeat the same mistakes that many before you have made. Short cut your learning curve wherever possible. Unfortunately, I have seen too many people jump into real estate investing and lose money because they didn’t have an adequate knowledge base from the beginning. The choice is yours. I hope you make the right one. This book will be one step toward your enlightenment as an informed investor.

#2 Q) HOW DID YOU GET STARTED IN REAL ESTATE? A) My parents owned some rental property and other investment real estate while I was growing up. Yet, it wasn’t their focus. I was around it, but it was never something they really intentionally exposed me to. I can’t say I grew up in an investment real estate family per se. At the same time, many in my family have been in the construction/housing related fields such as architecture, construction, and interior design. While I didn’t grow up talking about real estate, my family directly and indirectly exposed me to the benefits of real estate ownership. In fact, a portion of my college was paid for by my parents from the proceeds of the sale of a Wisconsin lake lot. Unlike some of the well known investment property gurus of today, my dad didn’t give me an apartment building for my birthday or teach me about becoming a landlord. I am self made in an almost 100% pure sense. Some of my knowledge was acquired from books/tapes while other parts were from actual experience. My original career intention was to become a doctor. I worked at a hospital while in college. It was because of that work experience that I made the decision not to pursue a medical career. I found that I didn’t enjoy that work environment. Instead, I was much more intrigued by the world of business and deal making. My background has been entrepreneurial from the start. I started as a caddy when I was 12 and ran a trapline in high school. In college I pursued a small mail order business and traded stocks. Real estate sales and real estate investing was the closest thing I could find that allowed me at age 21 to explore my desire to begin life as an entrepreneur. Here is how it all started. As a junior in college I was faced with not knowing exactly what I wanted to do when I graduated. Because of my undergraduate degree in biology, I was best suited for a medical or ancillary medical career, a medical sales job or research. Nothing sounded intriguing to me at the time. Then one morning, while reading the paper there in a full page ad was my future staring back at me. A gentleman, Al Lowry,


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“Reality Based” Real Estate Investing was conducting a free real estate seminar at the Thunderbird Hotel in Bloomington, Minnesota. Al was going to discuss how easy it was to make millions in real estate. I called up a friend and we attended together. This initial exposure was all it took for me to know that I wanted to get involved. I was bitten by the prospect of building a real estate empire with no money down and limited credit. It just so happened that I had plenty of both at age 20. Al said you could be successful with assumable mortgages and contract for deeds. This was exciting! When I returned to college my senior year, I knew what I wanted to do. I finished my biology major and management minor that I was pursuing at St. John’s University. While in my senior year at St. John’s, I attended the local Vo-Tech to get my real estate license. Upon getting my license, I sent out 3 résumé’s- one to Merrill Lynch Realty (now known as Coldwell Banker Burnet), Edina Realty, and Coldwell Banker. The office manager from Merrill Lynch called me in for an interview and offered me a job. This was the start of my real estate and real world career. Since that time, I have never ceased my quest or enjoyment for learning. I have three vertically integrated financial businesses: Real Estate, Mortgage and Financial Planning. One thing about real estate sales is that you meet all kinds of people from every walk of life. Through my clients, I’ve learned about many different career choices and different cultures. I may never have been exposed to many of these people except through meeting them during the course of business. To this day, some of my best friendships initially started as real estate client relationships. For better or worse, when you are dealing with money and negotiating, you often see a side of people that they don’t often present to the rest of the world. Human nature is a very interesting thing. People try to make decisions based on finances but usually succumb to making an emotional decision when making a real estate purchase. Purely financial decisions are made by computers. Humans make emotional decisions and then try to rationalize them based on logic. When finding property, I often compare it to falling in love. You just know when it’s right. While most investors buying investment property will claim they are able to make their decision more in terms of the numbers, the recent real estate price explosion in places like Florida and Arizona would suggest otherwise.

#3 Q) WHAT TYPES OF REAL ESTATE INVESTING HAVE YOU BEEN INVOLVED IN PERSONALLY? A) Here is a brief summary. I have sold approximately one thousand homes since 1986. In a normal year I will complete between 40 and 60 transactions. Transactions are defined as property sales of houses, duplexes, fourplexes, condos, townhouses, lots and raw land. Besides residential and investment property I have sold commercial office buildings and commercial land. I have also managed rental townhomes, condos,


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“Reality Based” Real Estate Investing duplexes, and houses for myself and family. Managing real estate means screening tenants, writing leases, coordinating workmen, collecting rent, and pursuing evictions. In addition, I have coordinated multiple 1031 exchanges for my clients. I have also worked on land development from raw land to finished subdivision. Some of the more creative/crazier things I’ve done in my real estate career include acting as the general contractor while moving a house onto a vacant lot and purchasing tax forfeited land from the state of Minnesota. Following Al Lowry’s advice, I have personally assumed FHA and VA mortgages and bought/sold property on contract for deeds. Lastly, I have bought foreclosed homes directly from the bank.

#4 Q) WHAT ADDITIONAL RESOURCES WOULD YOU RECOMMEND? A) I would recommend that you educate yourself to the greatest extent possible. This book is just one part of your quest for knowledge. You should continually buy additional books and tapes on real estate investing. If you are open to it, everyone can teach you something. Keep an open mind. When I first started, the real estate investment gurus that I read included William Nickerson, Ed Beckley, Al Lowry, Tony Hoffman, Robert Allen, Dave Del Dotto, Wade Cook, and Tom Hopkins. I learned a lot from these individuals. They gave me the tools and conviction to go forward and write offers. The key is taking action. If you just get the knowledge and don’t apply it, what good has it done for you other than provide entertainment? Gurus from the past are no different from the gurus of today such as Robert Kiyosaki, and Carleton Sheets. The common themes involve setting goals for yourself, taking action, and utilizing the tools that they give you to analyze opportunities as they present themselves. You’ll be surprised at what happens when you write down a goal. I still do annual goal setting with the sheets that were included in the Ed Beckley Home Study course some twenty four years ago. Goal sheets are simple, yet powerful. Goals are your blueprint for success. Another recommendation for you is to join investor clubs. These groups often bring in speakers and allow you to network with like minded individuals. Let’s face it, getting started and staying motivated is hard. It is even harder when you don’t necessarily have a crystal clear path on how you will achieve your goals. Many years ago when I first started, there was a chapter of the Charles Givens organization in the Minneapolis/St Paul area which I joined. I also joined the Minnesota Real Estate Exchangers and the Minnesota Multi Housing Association (MMHA). The first two groups are no longer in existence, but I am still a member of MMHA. If you want an advocate group to affiliate with, the MMHA is your group. Their membership fees are tiered to the number of properties you own. Their website is http://www.mmha.com. They sell a very affordable


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“Reality Based” Real Estate Investing forms kit that will cover most of your landlord tenant leasing and disclosure requirements. You may purchase the kit even if you are a non member, it just costs more. Next, you should look at who you want on your team of advisors as you begin to build your real estate empire. You have a choice. Do you want to work with a Realtor who has never owned or managed rental property? Do you know that most realtors don’t own rental property and have never owned rental property? Even in spite of the fact that we are able to see properties first. Also, we are able to buy property at a discount via receiving a commission off of the purchase price. Why would you work with someone who doesn’t or hasn’t done what you are trying to accomplish? In life, and especially in real estate investing, EXPERIENCE COUNTS. When you choose your trusted advisors make sure they have been in your shoes and walked the walk. Do they have the scars and war stories? Think about this: How can someone adequately advise you if they’ve never done it themselves? It is all about credibility. Harvey Mackay wrote a book entitled Beware The Naked Man Who Offers You His Shirt. The book title conveys what I’m trying to say. Your team extends beyond your Realtor. Who is your accountant, insurance agent, and attorney? Are these individuals experienced in dealing with rental property and the laws that pertain? You don’t want your experience to be one of you educating your team. Rather, you want your team to add value and educate you! Lastly, there are three books that I would recommend you read. While these books don’t directly deal with real estate investing, their life lessons can be integral to investing in real estate successfully. These books are as follows: 1) Think and Grow Rich by Napoleon Hill, 2) Tom Hopkins’ Official Guide To Success, and 3) Looking Out For #1 by Robert Ringer. All three of these books deal with human nature, psychology, negotiating and the power of goals. I know you will enjoy these books. Each book has had a lasting impact on my life. I would recommend them all as life lesson books. You will find that you will read them over and over again.

#5 Q) IS IT POSSIBLE TO BUY PROPERTY WITH NOTHING DOWN? A) In today’s mortgage market, there are products that allow you to purchase homes with nothing down. These products didn’t generally exist up until the past five years. If the seller were to pay for your closing costs and escrows, then you have a “nothing down” “100% financing” transaction. Mortgage programs are continuously changing, so the mortgage market may be different when you read this book. Currently you can get 100% financing with both owner occupied and investment properties. The investment property has to be one to four units. This means nothing larger than a fourplex should be considered.


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“Reality Based” Real Estate Investing Although nothing down may be possible, bear in mind that “something down” opens up more financing options. The interest rates are better with “something down”. Another way to finance a property 100% is if the seller agreed to finance part of the property in conjunction with you obtaining the difference in underlying financing. This can also be done if the seller agrees to carry all of the financing on a seller held mortgage or CD. While seller financing is possible, this is uncommon in today’s market. You should not expect to buy property this way.

#6 Q) PLEASE INTERPRET THIS STATEMENT: REAL ESTATE INVESTING DOESN’T MAKE SENSE TODAY. LOOK AT THE FORECLOSURE AND MORTGAGE CRISIS! A) AU CONTRARE! Now may be the BEST time to look at buying investment real estate. In general, do you like to buy at wholesale prices or retail? I think it is safe to assume that everyone loves a deal. When possible, we want a discount. I believe it was Baron Von Rothschild who attributed his success as an investor to buying “when there is blood in the streets”. Crisis is an opportunity if you know where to look and how to find it. Is your glass half full or half empty? You can always make lemonade out of lemons if you choose to do so. Investing in times of stress and duress will generally require you to have an expanded projected holding period. You need an adequate amount of time for the business cycle to change so that you can weather the storm and sell into strength. You need vision and courage. Are you thinking long term or short term? If you are thinking of “flipping property” in a stressed environment you will need to be very careful. If you have a time frame that is long enough to withstand the current crisis, you will do fine. This comes back to defining your goals with anticipated holding time frames. If you remember nothing else from this book-remember this: All markets are ruled by greed and fear. The risk-reward pendulum affecting every market will swing from fear to greed. It is constantly shifting back and forth. Successful investing demands that you become a contrarian in all your investing-sell into manias and buy into panics. Don’t follow the “herds of buffalo” or “lemmings to a cliff” as they make the wrong financial moves and perish on the rocks below. Human nature hasn’t changed since the beginning of time-only the names have changed. Recent examples can be found in Tulip Mania in the mid 1600’s to the various stock market crashes throughout time, the Great Depression of the 1920’s and 1930’s onto the most recent tech stock bust of 1999-2000. The story remains the same. If you can understand the basic tenants of human nature, you will be a master of anything you want to do in both life and investing. The current generation forgets the history lessons taught in the past. That is why we are destined to repeat the same mistakes every 20-30 years. Become a student of history and always invest as a contrarian. Sell into greed and buy into fear. Master this discipline and there will be no stopping you.


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LET’S BEGIN!!!!

Chapter 1 Setting Your Goals & Reality Check

Let’s get started! Now that we’ve covered the why let’s move to the how. I love the enthusiasm of a new real estate investor. I can relate to being in your shoes 23 years ago. We all start with grand visions of becoming the next Donald Trump or some other legendary real estate mogul. You have probably seen the infomercials on TV or know people who have been successful in real estate investing. Now you figure it’s your turn. ©2007-08 John Mazzara

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“Reality Based” Real Estate Investing I know you’re excited. I can remember listening to tapes, reading books and writing my first offers. Sometimes I would just get in my car and drive around looking at buildings for entertainment. I would fantasize about owning them. Other times I would take this a step further and actually go look at buildings and then write offers in an attempt to purchase them. I would tell my family that I was going to buy “this” building or “that” building. The only problem was that at age 21 and one year out of college, my funds were limited. However, where there is a will there is way. Needless to say, I tried and was not deterred by being broke. I would write nothing down or little down offers that required the sellers to carry some or all of the financing. Most of my offers were rejected. I must have written at least 20 different offers this way. These were great enthusiastic moments in my career as I was chasing the dream of becoming a real estate mogul. I was not to be deterred by the lack of offer acceptance. Eventually, with another real estate agent and his wife, we were able to purchase 3 duplexes with less than $5000 in about 1.5 years time. My persistence paid off. Today I am a successful real estate investor because I never stopped believing in myself. I never gave up. My first real estate purchase was a condominium in Edina. I purchased the condo by paying the cash difference between the asking price and existing mortgage. This was approximately $5000. I was able to do a non qualifying assumption on the condominium’s existing FHA mortgage. I bought the condo within 6 months after graduating from college. I didn’t have the cash available to use for a down payment, but I did have a Visa Card with a cash limit that was enough for the down payment. You could say that Visa was my silent partner in the beginning of my real estate careerCreative Financing 101. In fact, I’ve used assumable financing combined with contract for deeds on two of my three duplex purchases. Today things are very different. Sellers don’t want to act as the bank and carry financing. Assumable mortgages are really a thing of the past. The last non qualifying assumable FHA/VA mortgage was a loan originated in 1987. Most property today isn’t financed with assumable financing. Instead, we have a multitude of lender programs that may allow for up to 100% investor financing. Up until 2007, programs existed that allowed almost anyone to obtain a mortgage. Each year mortgage programs became more and more liberal. The loose credit standards contributed to the mortgage crisis that plagues us today. Recently, due to the foreclosure crisis, lenders have become more conservative. Lenders are once again concerned about how credit worthy a buyer is and his/her ability to make payments. This current tightening in the financial markets will change again in time. The financing program criteria will once again be more liberal. In the meantime, today’s tighter financial markets are helping create great opportunities for those who can qualify. You are in a great position if you have credit and verifiable employment.


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“Reality Based” Real Estate Investing As always, cash offers will trump any offer contingent upon financing. Today’s market is a huge opportunity for those investors who can pay cash. Sometimes obtaining cash can be as simple as accessing a line of credit against your primary residence.

Before you start buying property, I want you to understand that owning property is a process. The process should always begin with the end game in mind. This means either using goal template sheets like those in the Appendix, or creating something on your own. I realize that you can’t know exactly how long you will hold a property or how long you might want to remain a landlord. At the same time, you need to start with something in mind. You will want to review your goals on an annual basis or more often. When you do the review of goals, you can fine tune what you’ve learned based on your own unique experiences in landlording. Your goals will evolve. DO YOUR GOALS FIRST. PUT YOUR FINANCIAL BLUEPRINT IN PLACE. Please stop reading and remove the goal sheets in the appendix. You will notice we break down the sheet into where we are today and where we want to be in the future. Feel free to expand upon what I have provided. For those of you that don’t already own any rental property, you may not have any concrete answers to some of the questions. Put something down anyway. Your answers will define themselves in the future. Thinking you have to have all the answers before you start will lead to Analysis Paralysis. A common life mistake is doing the same thing and expecting different results. I think this is also known as the definition of stupidity. It doesn’t work like that in real life or investing. There is an immutable principal of trade offs. Are you willing to pay the price? Have you ever achieved a goal without paying a price? If you did I’m sure it didn’t have any lasting importance in your life or contribute to the character building of who you are. Successful real estate investing takes time so plan for it up front. Are you willing to take time away from the football games, fishing, your family and anything else that you enjoy doing with your free time? You need to be very honest with yourself. I want you to make a commitment to this before you start or resign yourself to where to you are today. If you are a dreamer, then stop reading this book. If you are a doer, keep reading as you will likely be successful. Remember that indecision by itself is a decision. Your real estate goals must be complementary with other goals that involve your family/spouse/significant other. If you don’t have the support of these individuals you will have resentment. Everyone must discuss and agree on the goals so that the sacrifices that will come with achieving them are understood, supported and appreciated. The following is an interesting quote to ponder from an unknown author: “Do what others won’t for 10 years and live like others can’t for the rest of your life”. Application and modification of this quote to your life will bring accompanying results. Unlike what you see on TV, real estate investing isn’t easy, without risk or without time commitments. It is about work. Work involves finding the opportunity and making


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“Reality Based” Real Estate Investing offers, adding value through improvements, managing the property, selecting tenants, and ultimately enjoying either the cash flow, appreciation or both. A profit will be your reward from the culmination of your efforts. Please understand that real estate investing is extremely rewarding. You will feel a sense of pride as you review your holdings. You will feel empowered knowing that you have chosen to add an asset class (real estate) to your portfolio which will reduce your dependence on other markets like the stock market. Ultimately, you can have freedom from your day JOB if you can offset your JOB income with the cash flow from your rentals. Do you know what JOB stands for? If you consider it an acronym, here is the definition: Just Over Broke. We all want liberation from a JOB if possible. If you haven’t filled out the goal sheets do it NOW. When you look at investing in real estate, there are three components that you will need to consider. Each property will have different metrics regarding the following components. THREE COMPONENTS OF EVERY INVESTMENT PROPERTY • • •

CASH FLOW-Could be positive or negative TAX BENEFITS-Depreciation of the building value and appliances APPRECIATION-Hopefully!!!

For younger investors with more time before retirement, appreciation and tax benefits may be the most important goal. On the other hand, older investors are more concerned about a property’s cash flow. Your evaluation and selection of a property will be largely dependent on where you are at that particular time in your life when you begin investing in real estate. Goal setting will help you focus on what you want an investment property to do for you financially. You need to be able to figure out how you want to structure your transactions to fit your goals.


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Chapter 2 Optimal Property Selection-You Have MANY CHOICES!

Don’t run out and buy any piece of property. Have a strategic plan. I suggest you start small. Small is good because if you make a mistake your financial damage will be limited. Small is generally less expensive. I also suggest you buy where you know the area. Do your investing within 45 minutes of your house. You are probably a local expert regarding the real estate within this time distance from your house. This means you should know a little about the crime, schools and amenities within the surrounding area. You can graduate in size and complexity of real estate holdings over time.


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“Reality Based” Real Estate Investing For example, consider buying a smaller house or condo and not an apartment building as your first property. Also, I want you to think about who you want to interface with as a tenant. Are you willing to own property in a higher crime neighborhood for the potential of receiving a better cash flow? Is this an acceptable trade off? This assumes that the tenants in these areas will actually pay their rent on time without your encouragement or involvement. Think about the hassle factor if you have to go out and collect the rent each month. There is a correlation between properties that cost more but are in more desirable locations that have little to no cash flow. Cash flow and the hassle factor are generally intertwined. Properties located in better areas may appreciate more and you might have less of a problem with your tenant. Life is short. How do you want to spend it? The following are pros/cons of various common and not so common types of real estate investment properties and strategies. I have included my analysis of the advantages and disadvantages. Use this synopsis and my experience to find an area of investing in which you feel comfortable. I have included, where possible, some personal examples of my involvement with each of these properties and strategies. Real world stories make understanding your choices easier. Feel free to pick and choose which types of properties are of interest to you today. Use this chapter as a reference to find future opportunities as you advance in your real estate investing endeavors.

Single Family Homes: The average price of single family homes within the Twin Cities metropolitan area is approximately $230,000. The rent you might be able to receive is anywhere from $1200$1800 a month depending on number of bedrooms and location. Today, I currently own one single family home as rental. I think this is one of the best opportunities in today’s market. Single family homes won’t necessarily cash flow but they currently are discounted heavily within our marketplace and should, therefore, be considered. If you can carry the property’s negative cash flow within your budget, I believe you will be rewarded with the future appreciation that will exceed the cumulative negative cash flow. Of course we can’t know when this will happen. In my opinion, when the real estate market swings back in favor of the sellers, single family homes will experience some of the best rates of growth in appreciation. Single family homes represent the majority of properties that are bought and sold in any given market. This means when you decide to sell your investment home you will have the majority of buyers and sellers available to you. You want the biggest market possible for your exit strategy to be maximized. Back in the early 1990’s, my fourth investment property was a single family home in South Minneapolis. I bought the home from a For Sale By Owner (FSBO). I paid a small amount of cash and assumed their existing loan. I then turned around and sold the home. I allowed the new buyer to assume the loan the same way I had assumed the loan. We wrote a contract for deed at the same time for an equity amount of $5000. The $5000 represented the equity that was in the home. My cost/benefit analysis led me to sell the


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“Reality Based” Real Estate Investing home within 30 days of purchasing it vs. keeping it and renting it out. Real estate in the late 80’s early 90’s had relatively low appreciation-2-3% per year. The amount I could receive on my contract for deed upfront was greater than the net rental amount I could receive if I held it as a rental. That is why I decided to sell the property. In retrospect, I wish I would have held onto the property as it quadrupled in value in about 10 years. Who knew it would quadruple in value? It goes back to the old cliché about hindsight being 20-20. Life tends to give you all the answers retrospectively instead of prospectively. I wish it was the other way around. ADVANTAGES OF OWNING SINGLE FAMILY HOMES There will be little competition from other landlords. Most rental property is traditionally in “multi-family” style properties like apartments and duplexes. This makes single family homes easy to rent as there are fewer of them available in the marketplace.

Your property will be in a predominately residential setting. This may allow for greater future demand and appreciation upon resale. Properties that are in more of a rental or commercial environment will appreciate less. Remember, you are expecting to sell to an owner occupant. Owner occupants want to live in residential areas. Owner occupants out number investors and should represent your ideal exit strategy buyer. Owner occupants are the ideal buyer for you because they buy on emotion, not on your building’s cash flow. . Residential properties, i.e. single family homes, have the highest demand on the real estate spectrum. Higher demand will give you more potential buyers upon resale. Niche market specialization is available. If you want to allow pets or smokers in your rentals, you are free to do so. Because you are not under the rules of an association you can make your own rental policies. Smokers and pet owners are an underserved client population. I simply wanted to point it out. I’m not recommending you rent to smokers and pet owners. We will be discussing why later in the book. You may be able to locate homes in areas that lend themselves to large remodeling projects, tear downs, or lot subdivision. This is a huge opportunity for the right buyer. This type of speculation is under the radar. It generally is a bit more expensive as the homes will cost more. If you can invest in a more expensive market you will face less competition. Certain communities such as


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“Reality Based” Real Estate Investing Edina and South West Minneapolis are perfect for this type of speculation. I feel this is one of the biggest opportunities in today’s marketplace. DISADVANTAGES Cash flow is limited as rents are low. This can be somewhat hard to overcome unless you have a large down payment. A large down payment will reduce your leverage. It will also reduce your ability to invest that cash in an alternative investment or the property itself. If you have negative cash flow, make sure it fits into your budget. There will always be some degree of obsolescence which includes the mechanics, the cosmetics and floor plan functionality. Most single family homes that can be purchased within the average price range of $250,000 are 30-80 years old. Investments in the building’s infrastructure seldom yields any return. For example a new roof, new furnace, new plumbing, etc are selling points but not real determinants of value. You expect a building to have these things. Therefore huge upgrades mechanically can leave you with a bad return on investment. Make sure you check the “bones” of the building. Houses tend to lend themselves to multiple occupants. You might end up having an extended number of people living/sleeping under one roof. Various cities have rules on the number of unrelated people that can occupy a house. You may inadvertently violate this rule. How are you going to deal with this and various laws on discrimination? Also, the neighbors will not appreciate all the extra cars parked up and down their street to accommodate your tenants. This is why I like SMALLER properties. By their design, small properties accommodate a smaller number of people. Cash flow is doubtful with a modest down payment. Rents are inelastic to some degree. This means you can’t just raise the rent and expect that the market will be willing or able to pay what you need to cover your monthly obligations to maintain the property. You must be able to absorb the monthly negative cash flow in your budget. The goal is to have any negative cash flow offset by the appreciation rate and tax benefits on your building. You are indirectly responsible for maintaining the interior and exterior of the building. Even if your lease calls for the tenant to do things like snow removal, you will be held accountable by the city or in court if it isn’t done. Even worse, if someone slips on ice on the sidewalk you will be sued. This highlights why you want an adequate amount of liability insurance.


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Lead based paint issues. This can be a trap. Watch out. Any building built before 1978 has a great probability of having lead based paint somewhere in the unit. This by itself does not necessarily create a health hazard. It is the dust or flaking paint that occurs with aging or negligence that will cause an issue if ingested. While it is harmful to everyone, it is especially bad for a child. You need to follow the disclosure rules regarding lead when you lease your property. A trap/problem could occur if you rent a property to someone who moves into your building from a building where lead based paint did create a health issue. The tenant and/or their children may get tested after they’ve moved into your building and have lead poisoning. If the health department inspects your building and determines that you have lead based paint in the building, they may determine that you were at fault. That is one battle I don’t want. Buying a building built after 1978 may be one way to resolve that problem. You can’t require that kids get lead based paint testing before moving in, so all you can do is hope for the best.

Duplexes/Triplexes/Fourplexes: Today, the average duplex might range from $250,000-$500,000. Rents for 1 br units are within the range of $800-$1000 and 2br units rent for $1000-$1500. In 1990-1991 I started buying rental property. The first properties I bought were duplexes. At the time, rental properties were priced so you could actually generate a cash flow with a limited investment. That has since changed. Today income properties are being marketed without any corresponding cash flow. The gloom and doom of the real estate market today is very much like it was in 1990-91. At that time, real estate as an investment was extremely out of favor. In 1990-1991 we were just coming off of the Resolution Trust Corporation (RTC) liquidation and feeling the final effects of Tax Reform Act of 1986. The RTC was liquidating foreclosed properties from defunct Savings and Loans. The Tax Reform Act changed the laws regarding depreciation of rental properties. The convergence of these events led to a great buying opportunity. The mortgage market crisis combined with the record number of foreclosures is creating the same analogous opportunity today. Today, all real estate is out of favor, not just rental property. In the current market, I would avoid duplexes/triplexes/fourplexes because I see little room for appreciation for a very long time. They are priced too high today. Many sellers who paid too much a few years ago are trying to unload their unprofitable building. Why would you want the work without an offsetting reward? If you can buy them so they cash flow, you might want to consider it. Unfortunately, I’m not seeing many of these deals. The best advice is to avoid multi-dwelling type of properties until such time that they are more reasonably priced. Without being able to count on appreciation for determining part of the property’s future value, you will need to focus on a property’s ability to return


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“Reality Based” Real Estate Investing acceptable cash on cash return. They call them income properties for a reason. They need to generate an income or you shouldn’t buy them. As previously mentioned, in 1990-91, you could actually buy a property with little to nothing down. In fact the first duplex I purchased was done by assuming the existing first mortgage and writing a contract for deed for the seller’s equity. It was a nothing down deal. The second duplex was done the same way but required $3000 down. Both properties were two blocks from Lake Nokomis. Other than the airplane noise, this is a very solid area within Minneapolis. I held these duplexes for 12 years. Interesting to note, I didn’t experience a big jump in my equity until the last 3 years of ownership. If I had flipped my duplexes too early, I would have missed out on the majority of the profits. Referencing a previous point we’ve already discussed, real estate generally is a long term investment that needs to be held through an economic cycle. Buy at the bottom of one cycle and then sell at the top of another. The reason my buildings appreciated so dramatically in the last three years of my ownership is because we had a perfect environment in which to be a property seller. We had the convergence of three huge factors: 1) huge demand for rental property and little available supply for sale; 2) lower property taxes in general and roll back in non homestead taxes in particular; 3) all time historically low interest rates coupled with easy to qualify for financing. Let me briefly explain each of these factors as the trends within these variables will determine when to be a buyer and when to be a seller. These will be discussed again in greater detail. REMEMBER-always be a contrarian in your investing. At the beginning of this decade we had a stock market bust. This market bust started in approximately year 2000 and continued for three years. This historic event of sustained negative returns in the market led many investors to look for alternative investments like real estate. For many investors, the prevailing thought of the day was that a piece of real estate doesn’t go to zero value and become worthless like some of the stocks of the day. Contrast this with many of the internet stocks that did go bankrupt. Validating and reinforcing the belief that real estate should be considered as an investment were success stories of ordinary people buying property in areas like Florida and Arizona. Ordinary investors were flipping property and making millions in a short period of time. Investor successes fueled the flames of other investor’s Greed. Remember, all markets are ruled by either fear or greed. The chance for any easy buck proved very alluring, i.e. greed runs amok. This is why there were so many new investors attracted to the marketplace. They all drank the “Flavor Aid”. This is an analogy to blindly following without having an ounce of skepticism or reason. Remember the tragedy surrounding Jim Jones in Guyana? All his followers perished in the jungle after they drank the cyanide laced Flavor Aid. The second factor was lower property taxes. For the first time in many years, we had a property tax refund and property tax reduction. Lower property taxes improve a property’s cash flow. The greater the cash flow, the more debt (mortgage) a property can support and hence the greater the value of the property. Lastly, we had low interest rates with easy to qualify for mortgage programs. Lower interest rates allow for more debt (a


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“Reality Based” Real Estate Investing larger mortgage) to be placed against a building. This leads to a higher valuation of a property. I recognized these factors in the marketplace and realized it was time to be a seller and not a buyer. This is why I promptly sold my duplexes at the end of 2002. As you become a student of markets, you too will be able to predict mania’s in the markets. This will allow you to take advantage of over bought and over sold situations. We will discuss more of this later.

ADVANTAGES OF OWNING MULTI-FAMILY HOUSING You have one building generating two income streams. When a building is vacant, the vacancy is usually limited to one side only. This means you still have some income from the other side to offset the expenses. This is in contrast to a single unit property where you have no income when vacant.

It is easier to manage everything in one location vs. having to visit two properties. Consolidating everything under one roof may be cheaper than maintaining two roofs. It is also easier to drive your car to one building instead of multiple buildings. DISADVANTAGES Most duplexes are built on busy streets that have multiple investment properties all around them. This tends to generate a “tenant” vs. “owner” mentality. There is a greater probability of absentee landlords not caring about their property. Adjacent properties subsequently fall into greater disrepair more easily. Even if you are a great landlord, that might not be the case with the owner of the building next door. One bad apple (landlord) can spoil a street. Some landlords just care about filling the building. Today, more cities are holding the landlord responsible for crimes committed at their properties. This should help encourage a better initial screening of the tenants. In fact, there is something called the RICO Act which can cause a property to be forfeited if the landlord knowingly allows certain types of crimes to be committed on the premise. Tenants selecting a duplex are doing so when they could have selected an apartment building that offered greater amenities. A duplex/triplex/fourplex tends to have greater obsolescence because they are older than newer apartments. There may be a correlation between lower rents and lesser qualified tenants unless the location is exceptional-such as across from a lake.


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“Reality Based” Real Estate Investing There will always be some degree of obsolescence which includes the mechanics, the cosmetics and floor plan functionality. Most multi-family investment properties that can be purchased within the average price range are 30-80 years old and are within the core cities or first tier suburbs. You will find that most floor plans of multi-family properties that were built during the same vintage are the same. Where is your property’s competitive edge? You may need to update the property cosmetically to give you an advantage over identical properties that exist within the same area. Since they are almost all the same in size and function, location will be one of the most important considerations. Duplexes are bought primarily by landlords. This isn’t to say that some aren’t sold to owner occupants. But when a landlord buys a building, he/she usually expect some kind of immediate return on their capital. A multifamily purchase will be evaluated as a semi- non emotional purchase and more of a return on capital analysis. This will limit your appreciation and upside unless rents are projected to increase greatly over time. Net income, which is a function of rents and expenses, will be the driver of future appreciation. Rental rates are subject to supply and demand. Currently there is a lot of supply. Cash flow is doubtful with a modest down payment. You must be able to absorb your property’s monthly negative cash flow within your monthly budget. The goal is to offset the negative cash flow by the appreciation rate and tax benefits. Can you still do this with an extended vacancy? The answer is probably no. That’s why location is so important. You are indirectly responsible for maintaining the interior and exterior of the building. Just as with a single family house, even if your lease calls for the tenant to do things like snow removal, you will be held accountable by the city or in court if it isn’t done. Even worse, if someone slips on ice on the sidewalk you will be sued. Lead based paint is still an issue. We’ve discussed this with single family houses already. It applies here, too. This can be a trap so watch out. Any building built before 1978 has a great probability of having lead based paint somewhere in the unit. This does not necessarily create a health hazard. It is the dust or flaking paint that occurs from old age or negligence that will cause an issue if ingested. While it is harmful to everyone, it is especially bad for a child. You need to follow the disclosure rules regarding lead when you lease your property. A trap/problem could occur if you rent a property to someone who moves into your building from a building where lead based paint did create a health issue. The tenant and/or their children may get tested after they’ve moved into your building and have lead poisoning. If the


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“Reality Based” Real Estate Investing health department inspects your building and determines that you have lead based paint in the building, they may determine that you were at fault. That is one battle I don’t want. Buying a building newer than 1978 built may be one way to resolve that problem.

Apartment Buildings: Most investors that are just starting out should avoid apartments as their first property. In my opinion, apartment building investing is for the professional investor who can make completely unemotional decisions based on cash flow. Because of the cost involved, most small apartment building investors generally are able to invest in 5-18 unit buildings. Outside of our core central cities which have an even older housing stock, most of these types of buildings were built from 1940-1970. There is a lot of obsolescence in these buildings and these buildings are the least desirable places for a tenant to live for a number of reasons. Rents for these buildings are generally lower than in newer buildings built today. Therefore, you tend to attract a tenant base that has fewer options open to them. Early in my real estate career I pursued a six unit apartment building. It was a 1960’s building in South Minneapolis. It was being marketed on behalf of a family that had placed it in trust with a local bank. I made a full price offer that involved the seller being part of the financing. They received another offer at the same time that was lower than mine but was for cash. They accepted the other person’s cash offer. Have you ever heard the saying “Thank God for unanswered prayers”? Sometimes things happen for a reason. Subsequent to my not acquiring the building, crack cocaine was introduced into Minneapolis. As chance would have it, the block in which this building was located happened to become the epicenter of the burgeoning crack epidemic. To make a long story short, the buyer of the building sold it two years later for $25,000 less than he paid. That buyer sold it again two years later for $25,000 less than he paid. Needless to say, I am glad I did not acquire that building. I also considered buying an 11 unit building as part of my initial investment property blue print. I had a theory that buying a building in a more transitional neighborhood with the potential for better cash flow would allow me to buy a better building in a better neighborhood with negative cash flow. The two buildings would offset one another. I would be able to net the two buildings cash flow against each other. I made an offer on the apartment building for $100,000 when it was listed for $200,000. I wanted to be able to keep it half occupied if necessary and still be able to make the financing payment. Too many landlords have too much leverage against their properties. High leverage often leads these landlords into accepting tenants they might not otherwise want to accept in order to cover their mortgage. I didn’t want to be in that situation. If the area improved I would be able to fill the building with acceptable tenants. At the same time, by paying $100,000 for the apartment it wouldn’t be required nor expected in order to keep the building going. I would be able to have the building 50% occupied all the time and still be able to cover the buildings mortgage obligation, i.e. debt service.


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“Reality Based” Real Estate Investing Sometimes when you are making or negotiating an offer another buyer will appear. That’s what happened to me. This new buyer stepped in and paid full price. I know they paid too much because they didn’t do their homework on the area. I subsequently never followed up on the building’s history to see if that buyer defaulted or if they still own the property. At about this same time, I decided to abandon my multiple building cash flow offset plan. I decided instead to focus on affordable duplexes and small single family houses. I came to the conclusion that life was too short to be involved with marginal properties. About 10 years later, a third apartment building was marketed to me directly by a seller. It was a 10 unit apartment building and included an adjacent vacant lot. I had the building under contract to be purchased for $150,000, subject to a two week due diligence period. This sounds like a great deal doesn’t it? You will soon find out it wasn’t. Next, I hired an inspector to go through each of the units and the entire building. We spent about five hours evaluating the building. Once I had the building evaluated, I was able to create a list of required repairs. Next, I started getting bids for the work. The bids totaled $350,000. These bids only represented what I knew and could foresee. Anyone who has ever done an extensive remodel understands there will be a cost overrun. It is typical to run 20-50% over in many cases. Needless to say, what looked like a good deal for $150,000 was actually over priced. Before the two weeks ended, I approached the seller with my data and told her I was unable to pay more than $50,000. The seller agreed with my numbers and the required repairs. Although she agreed with my assessment, we were not able to come to an agreement that was satisfactory to both of us. I did not buy that building. This is the value of performing due diligence and not becoming emotionally attached to the investment property. I didn’t care about the brick and stone exterior, hard wood floors, etc. I only cared about the numbers. Either the building “worked” or it didn’t. If I had just reacted to what appeared to be a good value and had fallen in love with the old world charm, I would have spent too much on the building and lost a ton of money. These three apartment building experiences were enough for me. Not to say that I wouldn’t consider a really good deal if it fell into my lap. I just won’t be proactively seeking these types of properties. ADVANTAGES OF OWNING AN APARTMENT BUILDING There is an economy of scale that happens when you have all the units housed under one roof. If you are able to locate a building where the rents are below market and can be raised to the market rate without losing tenants or having to invest a huge amount upgrades, then you will have a winner. The key with apartment building investing is being able to add value where the previous owner failed. Success may be because of your better management skills, making strategic value adding upgrades and/or being lucky enough to catch a changing market.


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There is the possibility for non recourse financing. Another positive of apartment building investing is that you may be able to get non recourse financing. Your intention from the beginning isn’t to default on any loan. Yet, non recourse financing means that the building stands as sole collateral for the loan and makes it easier for you to walk away from the building if necessary. The alternative to non-recourse financing may involve signing a personal guarantee. This means you and your assets personally stand behind the loan in the event of default. Given a choice, which type of financing would you prefer-non recourse or recourse? With an apartment, you may also find a seller willing to carry back some financing. This may or may not be combined with some underlying assumable financing. If you are dealing with seller financing, better terms will generally follow a stronger down payment. In general apartments are harder to finance for buyers. There are fewer outlets for apartment financing. This is why sellers frequently are involved in financing the new buyer of their properties. Don’t forget, someday you too will be the seller and will likely face many of the same financing constraints with your buyers of the future. Remember, how you buy may be how you sell.

DISADVANTAGES These buildings are evaluated by their respective cash flow. This might not necessary be a negative, but generally you would prefer to have an emotional component to your building if possible. Apartments are valued off of a capitalization of the net income generated by the building. This is termed a “cap rate”. Generally speaking, the cap rate is lower for nicer properties. The cap rate is higher for less desirable properties. Did you notice I mentioned nothing about the actual cost of replacement of the building? A building’s valuation is all about the return on investment as calculated by the building’s specific and reoccurring cash flow. This means current net income and projected future net income. The amount of financing available is a function of the cash flow. The lender wants to have a certain DCR (debt coverage ratio). This means they want to know that the rents can carry the mortgage. Think about the capital that you have to invest in real estate. As an investor, you expect a return on your invested capital. You have many options on where to invest. Generally speaking, capital flows to where appropriate risk and required return intersect. The resultant investment could be mutual funds, stocks, bonds or real estate. Since real estate is a “more hands on” investment which requires more work, you will generally need a hybrid rate of return between that offered on stocks, mutual funds and bonds. This hybrid rate of return is generally in the range of 9-13%. If you can’t generate that type of return on the real estate, you might be better off with the alternative investments. The valuation of your net income and hence your building, is always subject to the yields offered by competing investments.


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Let’s review obsolescence too. Here are some of the things you find in older apartments: small kitchens, old appliances, outdated bathrooms, inadequate parking, no amenities, no high speed internet or cable, bad windows, old mechanicals, poor construction and little to no sound proofing. Compare those issues against a new apartment complex that has been built to correct some or all of these issues. Where would you move if you were a tenant that had choices? Who are you most likely to attract to these older buildings? The answer might be tenants without many choices. Bad credit and other issues may accompany these types of tenants. Mechanically, many older apartment buildings are going to need some work. Some owners milk the building’s cash flow and do as little as possible to maintain them whereas others put money back into their buildings and take pride in ownership. The 10 unit apartment building that I chose not to purchase hadn’t been updated mechanically in many years. Because there had been so much deferred maintenance the building would soon become a money pit where the new owner would spend an endless amount of money. A money bit refers to a property that continually requires you to spend money to keep and maintain it. Based on the asking price, that building wouldn’t allow for any return on invested capital. You might remember that we talked earlier in this book about a building’s infrastructure. Remember that investing in the mechanicals and the shell may not increase the building’s value. In the case of the 10 unit, everything was in need of updating in the amount of $350,000. Do you want to be the property manager? Apartment buildings are much more time intensive to manage. If you don’t want to manage your building, then you will need to hire a manager. This takes away cash flow which, in turn, lowers your return on your investment. What is your time worth? When is the last time you saw an owner occupant buy an apartment building and live in a unit as his/her primary residence? I’ve never seen this occur-but that doesn’t mean it doesn’t occur occasionally. That being said though, it probably means your exit strategy will involve, primarily if not exclusively, other investors. Investors by nature don’t want to pay retail for anything. Think about negotiating in that type of an environment with a limited number of investors in apartments. It is an ugly picture isn’t it? I think you will have a more profitable and pleasurable experience with a different category of real estate such as single family homes.


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Condo’s/Townhouses/Lofts: Often, new/upscale condos will rent for more than a typical upscale apartment. Condos and townhouses typically attract an older tenant who wants to avoid the busy activity that often occurs at apartment complexes. This is the type of tenant to whom I like to rent my property. There may be a correlation with maturity of the tenant and their age, although I’m sure many of us know some pretty immature older individuals and some younger people who are wise beyond their years. As a generality though, your older tenant should mean a quieter tenant who wants to live a little more sedate lifestyle. I have found that if you buy in a bedroom community you will often attract a divorced parent, a relocating employee or possibly a family. If you buy into a project that is closer to a college or the heart of the city, you will typically attract a younger tenant who is interested in a bit of the night life. That type of tenant moves more frequently. Greater tenant turn over means more work for you. A bedroom community may also be known as a commuter community and is defined by Wikipedia as follows: “A commuter town or bedroom community is an urban community that is primarily residential, from which most of the workforce commute out of the community to earn their livelihood. Most commuter towns are suburbs of a nearby metropolis that workers travel to daily, and many suburbs are commuter towns.” Regarding the age of a project, older projects or projects with fewer amenities, will generate less rent. Also, older projects will have less appeal overall and will result in higher vacancies. This is why I like newer projects. When evaluating a project and community, you need to always consider the competition from newly built apartments or other new rental condominiums as these are your primary competition for tenants. In some communities you will find recently built, very nice apartments with all the upgrades-CAT5 for high speed cable/DSL, swimming pools, health club/workout rooms, stainless/black appliances, maple millwork, large windows and often a month or two of free rent or even a free TV if you sign a year lease. Eden Prairie and Woodbury are two communities that I would avoid buying rental property in because of the competition from great apartments. Within these types of communities you will find the competition for tenants is fierce. If you own a rental condo/townhouse, you will probably not generate enough rent to cover your mortgage unless you put down a large down payment. On average, the rents for one bedroom units are $800-$1000 and two bedroom units are $1000-$1500. This amount of rent doesn’t equate into much of a mortgage-approximately $120,000-$180,000. I own three lofts/condos at the moment. I’ve chosen to focus on communities that don’t have a lot of new buildings. I own my buildings in Hopkins, Richfield and St. Paul. These are good examples of owning property within a core city and the first tier suburbs


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“Reality Based” Real Estate Investing that surround them. I don’t have much competition with newly built properties. You want as many competitive advantages as possible. With all projects, you are buying into an association with rules and regulations. The exterior and interior common spaces are maintained for you. Your main concern will be finding an acceptable tenant. I would focus on what makes a project unique within that specific community. For example, is it the only new project built in the past 10 years? Is the location preferential? Does the project have amenities such as an exercise room or community room compared to competing apartments or other projects don’t have any common space? What would make this property have a competitive advantage within the rental community? Smaller units are generally cheaper and more affordably financed. Interestingly, most new buildings that are built today barely have adequate parking. Usually you get one underground parking stall. You may run into parking issues if you buy a two bedroom unit that doesn’t have two parking stalls. What happens if you have two tenants that drive and one doesn’t want to park on the street? You may lose that potential tenant. Many developers will be happy to sell you an extra stall for an additional $15,000$40,000. I would tend to discourage buying an additional parking stall as I believe they cost too much and are a bad investment. Instead, I prefer to buy one bedroom units or studios that can be redesigned into one bedroom units. Based on functionality, you will probably get a single tenant who will be satisfied with having the one parking stall included. As for design, I prefer the loft style building up to six stories or a townhouse style unit. I wouldn’t advise buying a unit in a high rise tower style building. The higher association fee associated with most towers is hard to overcome when you are renting. Usually a tower is sold at a much higher cost per square foot because they are more expensive to build. Rent is relatively static based on the unit’s size. Translation, towers should be avoided. I bought my condos at the beginning of the condo craze in 2002 and 2003. When I bought them the market was growing and became frenetic. Today we are saturated with more condos than buyers. This means more units that can’t be sold are being rented. Greater supply leads to more competition in the rental arena and subsequent rental price compression. Even though the market is tough, I still feel good about my units because I bought in strong areas using the criteria I’ve outlined above. My recommendation is to buy in the beginning of a project when the developer hasn’t even broken ground. The developer usually doesn’t start to break ground until they have pre-sold a certain number of units. The banks want to know that the project has a great chance for success prior to lending money on the project. In order to get the project going, I’ve found that the developer will offer you more incentives if you buy in the beginning. Developers will leave money on the table at this stage. They feel they can make it up on future price increases on the other units. You may be offered free upgrades such as fireplaces, granite, upgraded millwork, etc. These freebees have real value. You will be able to monetize the incentives into dollars when you decide to sell the building in the future.


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In general, when you buy a “to be built” project you will find that you have to place 3-5% down at the time of signing the purchase agreement. You pay for the rest of the unit when it is completed and you close on it. Building a condominium project can take up to 24 months. This means you will have “free” appreciation during this time. Also, if the project is being built in phases, the last phases always cost more. Increases in condo prices occur due to cost increases in building materials, labor and on what the market will bear. Assuming a rising valuation, your unit will get a “pull up” in value when compared to the prevailing cost of the new units. ADVANTAGES OF OWNING A CONDO, TOWNHOUSE, OR LOFT Your primary concern and responsibility is in finding a good tenant. All the other issues with older buildings such as obsolescence don’t apply. The association and management company are in charge. Some of the major obstacles to your success have been removed; however, you still have to find the right tenant.

You may be able to locate a building in an excellent location. Many projects are redevelopment or infill in older cities. You might be able to invest in your favorite community and not have to drive to an outlying suburb. Your resale will most likely be to an owner occupant. In the meantime, you will not have to compete as hard with other rental units within the building or within the community. Most units in a typical project will be bought by owner occupants. This means these types of property are not often sought out by landlords who are seeking to buy rental property. Therefore, you will own a great property and not have a lot of competition from other landlords within the building because most units aren’t being rented. If you buy in an older community that does not have a lot of current building going on, you will be competing with 40’s, 50’s, 60’s and 70’s built apartment buildings. Regarding the competition, you might not have any that can compare. Your brand new updated building, possibly with amenities, will win hands down. You have eliminated the obsolescence factor that you have with older properties if you purchase a new or newer building. This makes your building more competitive and will help you save money on updates that you don’t have to do. Your biggest expenditure will be in purchasing new window treatments. You are able to get a break on taxes for approximately the first 18 months of ownership in a newly built building.


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Minnesota has a non-homestead tax classification for rental property. The nonHomestead taxes assessed against rental property cost more, reducing cash flow. The actual tax assessment for all property in Minnesota is based upon the value of the building as it stands on January 2nd one year prior. Taxes payable in the following year are based on the valuation assessed one year prior. Since your rental unit was either a piece of undeveloped land or part of a partially completed project, your taxes will be lower in the first 12-18 months of ownership. Partial completion of a building translates into lower taxes which results in better cash flow, at least initially. Don’t forget to factor in the non-homestead vs. homestead tax differential in your extended property ownership analysis. If you purchase a new construction development that is done in phases, you may be able to benefit from a natural increase in the price of the same unit in a subsequent phase. I sold my phase one Emerald Gardens condominium as they were starting to sell phase four of the project. I was able to earn a 200% return on my invested down payment within 18 months of my initial closing. I will talk more about this property in the section on financing.

Another advantage of buying a brand new condo/townhouse or any new construction is the HOW 2-10 warranty. The builder must provide this warranty to you by law. The warranty covers the mechanical items for two years and the structure/foundation for ten years. The warranty is available to collect from if the builder won’t fix the items or if the builder becomes insolvent. Appliances are generally covered by the manufacturer for one year. These warranties should provide you more protection and piece of mind as a landlord. These warranties transfer to any new buyer so they will become selling points down the road. DISADVANTAGES You are subject to the rules, regulations, and bylaws of the association which are subject to change by quorum. If you or someone else who owns a unit in your building doesn’t act responsibly as landlord, there could be a backlash and a change of the rules. There is no guarantee that you or your lease with your tenant will be grandfathered in should there be a change eliminating your ability to rent your unit. You could be forced to break a lease and sell your property at the worst possible time in the marketplace. Also, there doesn’t have to be a problem for the association to change the rules. Association members can do it just because they want to. If they have the necessary votes, the rules will change.


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“Reality Based” Real Estate Investing This was attempted in one of the projects in which I own a unit. We quickly mobilized the landlords, hired an attorney and attended the association meeting. Because we were very proactive, we were able to convince the residents that it was in their best interest to leave the rules unchanged. Bear in mind our interests were secondary. You will need to be able to persuade the owner occupants why it is in their best interest not to change the rules. You are not able to do whatever you want with your property. Some associations prohibit renting a unit. Be prepared to get very involved should you need to organize and educate the resident owners on the benefits to THEM for allowing rentals to continue. Your tenant can’t have wild parties. Remember this is community living. Everyone will have to act accordingly. If you have bad tenants, remove them as soon as possible or expect a backlash. You will have an association fee that you have to pay. Typically a tenant will not pay this-even if it includes such things as the heat, water and sanitation services. You will need to factor this into your cash flow analysis. If rent is inelastic, you will be absorbing this cost. If it was a house, the tenant would be expected to pick up the cost of some of the things included in the association fee.

Fixer Uppers-Of Any Kind: Unless you are in the trades and can do the work yourself or at wholesale, I would highly advise against pursuing these properties. Fresh paint and new carpet hardly constitute the necessary work on a fixer upper that will yield you tens of thousands in profits. Yet, when you watch some of the late night TV shows or read some other real estate books, they suggest getting ready to make a big profit is as easy as just painting. I’m here to tell you it isn’t. The competition for moderately priced fixer uppers-$150,000-$400,000 is intense. You are competing against people who will do the work themselves and evaluate the return/profit as being equal to what they would have earned on a job. As an investor, you will never win in that situation. If you want to play in this game, you need to go upper bracket. Let’s use $400,000 plus as an example. Ideally you would find a smaller property in a more expensive neighborhood that would lend itself to an addition or tear down and rebuild. You could hire out the work and resell the property in that situation and have a good chance of earning a profit, but the financial risks are much greater. In addition, you will always go over budget, so plan on that from the start. A profit can quickly turn to a loss when you are over your budget.


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“Reality Based” Real Estate Investing ADVANTAGES OF OWNING A FIXER UPPER There should be a corresponding discount beyond what the cost of the work will be to bring the property up to full market value. If you are able to do the work for less than the discount in the price, you will have a built in profit. If you have access to reasonable tradesmen, you might be able to make a profit. If you do the work, you need to factor in a value for your time. DISADVANTAGES Competition on the lower end of home value is fierce. Other than buying direct from a private party, don’t expect to find any bargains in this price range. This is how the people who buy ugly houses make a profit. Often, they are the only ones negotiating directly with the seller. This does not create a competitive environment You may get your best bargains in transitional neighborhoods. The problem is you don’t always know which way the neighborhood will transition. Guess right and there is a nice profit. If you guess wrong, you will lose a lot of money. One last consideration is an inspection. Many first time buyers will have an inspection addendum as part of their purchase agreement. I recommend that you at least consider having an inspection done on the fixer upper. Things like asbestos can be very expensive to remove. Unless you are experienced, you might miss some of these time bombs. For a property that is brand new, an inspection might be unnecessary. You will want to have more thorough inspections as the housing stock you purchase gets older. Financing for this type of work is difficult to obtain. The best way to finance these projects is with a line of credit. The line of credit is like a credit card. It can be accessed, paid off, and accessed again and again. If you use a mortgage for acquisition, you may run into restrictions from the lender regarding the work that you can do and the type of insurance you must carry. In addition, it will cost you about 3% every time you obtain a mortgage. This will be a big part of your flipping expenses. Add this to the traditional real estate selling costs, and you will be out about 9% before you even can begin to calculate a profit. You will need to have this figured into your profit analysis. You will find that many “rehabbers” will become Realtors so they can list their properties themselves and reduce some of their buying and selling expenses.


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Land/Lots: Some people like to speculate on land. With land, you seldom have tenants. This is both good and bad. Tenants cover the debt service associated with owning the property. Without any income, you have to cover the mortgage debt service, insurance and taxes. Raw land can be a cash drain or alligator that needs to be fed. If you buy farm land, you may be able to rent it to a farmer in the community or put the land in a CRP program and receive rent from the government for not farming the land. The CRP acronym stands for Conservation Reserve Program. This program encourages landowners to let their land return to a more natural state. Direct benefits of this program include providing additional land for food and habitat for wildlife while at the same time reducing runoff and soil erosion. I have bought vacant lots in the past, both on the open market and as tax forfeited land. I bought the lots so that I could complete a house move project and possibly build some homes on speculation. Sometimes buying a bigger piece of land that offers development possibilities is the way to go. Also, finding a house on a lot that can be subdivided is rare, but possible. You can have your Realtor set up land searches for acreage via the MLS. You will be surprised at what occasionally becomes available. Be prepared to act quickly because these types of properties won’t last long. I found my current home in Edina on 1.75 acres via the MLS. In fact, it was actually on the market for 10 days before I found it hard to believe but true.

ADVANTAGES OF OWNING LAND OR LOTS I think Will Rogers said it best “Buy land. They ain’t making any more of it.” Land is a finite commodity. The population is increasing daily. Someday the world will come to you. In the meantime, the land is expensive to own while it sits dormant. Buying a property or piece of land that can be rezoned may present an opportunity. Try and focus on land that is in the path of development and might be annexed into the water and sewer master plan-called the MUSA line. Expansion of the MUSA will offer you the opportunity for subdividing. Here is the link to a recent MUSA line study http://www.metrocouncil.org/planning/landuse/LandStudy.pdf. Also, consider visiting your local city office and talking with the city manager. Reviewing the current planning and zoning maps is essential for seeing where these opportunities may be present. Sometimes you can pay to extend utilities to an area that is right on the edge the MUSA line. Imagine the change in value that would occur if you were allowed to convert a large acreage parcel into more moderate .25 to .5 acre lots.

DISADVANTAGES


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Unfortunately, you are unable to control the business cycles that exist in the world. This means that you may often be holding the land longer than you anticipated. Make sure you have enough capital to extend your anticipated holding period should you be faced with this situation. Zoning laws and setback requirements can change over time. When you buy a piece of land, you may have an intended purpose for the property or you may want to build a specific type of building on it. If you wait too long, you may find that the city/county/DNR or some other regulatory body may come in and change the rules affecting the property. Usually, changes restrict what you can do, not liberalizing what you can do. This could change the value of your holdings overnight. Submit your plan to the appropriate office or agency for approval sooner rather than later. Then start to build. Waiting can be perilous to your financial health. A few years ago I marketed and sold a lake lot for a client in Mound, MN. The new buyers were granted a one year variance by the city council to build their new home. In order to do this, we had to appeal to the city council and planning commission. Today, I doubt that they would have allowed that same house to be built. In fact, the city told my clients “no” initially when we went before the city council and planning commission. We threatened to sue them, which we would have, except they reconvened after we left the city chambers and they voted to overturn their initial “no” vote. In my opinion, the cooperation and understanding between a city and homeowner for granting a variance is not as friendly as it once was. This is why I tell you to do it now.

Building Homes On Speculation Or Moving A House: Being involved in a new construction project is exciting. You will access your creativity to design and pick out the various components that will go into the final project. At the same time, it is also the most frustrating experience you will ever be involved with. Almost every variable in the building process is out of your control. Please accept that as an absolute truth. The weather and coordination of various contractors will drive you crazy. A project of this magnitude is very time consuming and risky. If you don’t have the necessary time or supervisory capabilities, you should skip this type of real estate project altogether. Initially, some projects may appear to have great profit potential. An example of this is a home which I purchased to move to another site. When I did my house move, I bought a house in Richfield and moved it to So. St. Paul. Here were some of my major costs: Three bedroom rambler with a detached 2 car garage-$17,000


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“Reality Based” Real Estate Investing Cost to move both onto the lot-$11,000 Vacant lot-$15,000 I should clarify that this occurred back in 1993, so the prices sound really good. For the record, I sold the home for $93,000. You will soon find out that it wasn’t as profitable a venture as it could have been. In the end, you may make a substantial profit only if everything works out perfectly. At the same time, very small mistakes can magnify your costs as they cascade throughout the project. For example, when I moved the house and acted as general contractor, I didn’t have the excavator dig the foundation as deep as I should have. While the excavator followed the survey and the diagram he was given, I should have asked that he go two feet deeper. These two feet cost me approximately $35,000 in additional costs. I would have saved the cost of two extra egress windows, stuccoing the lower half of the building, repainting of the entire home, adding additional concrete steps with hand railings to account for the higher elevation and extra brick work. Besides the cost over runs, I had to deal with a neighbor to the North who was very unpleasant. She was a woman who had nothing better to do than harass me. As it happened, I bought the vacant lot that she had previously used as a play area for her in home day care. Of course, she, too, could have purchased the lot when it was for sale, but she opted not to do that. Instead, when I started my project she decided to call the city on me almost on a daily basis. I dealt with a city inspector who was actually a pretty good guy and was as empathetic as he could be to my situation. At the same time he had to respond every time the neighbor called. The neighbor played both sides of the fence. On the one hand, I was the enemy. On the other hand, I was a profit center. If any of my contractors needed something like electricity or water, she would sell them access. This went on for five very long months. I spent five months of my life, countless hours and many sleepless nights focused on the project. At the end of the day, I ended up making $5000. The one redeeming thought throughout the process was that at the end of the day, I was able to go home and be “me” while at the end of the day the neighbor still got to be “her”. Winston Churchill said it best. I love this quote: Bessie Braddock (to Winston Churchill): “Winston, you’re drunk.” Churchill: “Bessie, you’re ugly. But tomorrow I shall be sober.” I think you get my drift.

ADVANTAGES OF SPECULATION You might be able to get a great buy on a lot, materials, or labor. You might be able to be your own general contractor and save the typical 20% mark up on a newly built home. Make sure you do a cost analysis of your time being focused


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“Reality Based” Real Estate Investing somewhere else in lieu of being the general contractor. You may find that you are better off hiring someone to wear the construction manager hat during the project. DISADVANTAGES You need to be a master coordinator over variables which you have absolutely no control. Building a new home or engaging in a major remodel of a home is usually done in stages. You need to schedule each contractor to come in after the last contractor has completed his work. For example the plumber may need to come in before the drywall person. The hardest thing to deal with is trades people that don’t show up when they say they will. If somebody doesn’t show up or doesn’t finish on time, then it throws everyone off schedule. Usually contractors are bouncing from one job to the next, so it isn’t like they can just come and go at any time. Once one contractor gets off track, your entire schedule can be thrown into disarray. In addition, you have weather issues that are beyond your control. What if it rains for two weeks straight? This will require you to coordinate and reschedule. In the beginning, you always have your first project. You may quickly determine that your first project is your last project. Here are some additional considerations. Some contractors will put you on the “B” list from the start because they view you as a one time job and not a source of continuing business. The “B” list means you don’t get the same service or same pricing as the “A” list. Fortunately, some contractors will try to help you. At the same time, others will try to take advantage of you and your naiveté. Unless you quit your day job, you are probably going to be offsite at your other job trying to make a living. The other job is the one that pays the bills. This places you at the mercy of others since you are not there to supervise. On my projects, I’ve dealt with both good and bad contractors. Thankfully, the majority were good. Make sure you aren’t committed to a “time and material” arrangement unless you are there to supervise or unless you trust the contractor. Compound these problems with neighbors who may be resentful that you have just turned a vacant lot that used to be viewed as a source of privacy into a construction zone replete with noise and mess. As I mentioned here, some neighbors are more than willing to call the city inspector and complain. Overall, I’d have to say that it was a good learning experience but one that could have happened if I had watched someone else’s project. My conclusion from this experience was that I never wanted to do another house move again. It took 10 years for the memory of the pain to fade before I repeated a similar experience with my own home remodel. I did an extensive 20 month remodel on my primary residence with a very similar outcome and similar set of experiences-primarily with the contractors. One major difference during this process was that my neighbors were WONDERFUL. They were extremely patient through all the noise and mess. My conclusion for you is this: leave building to builders and buy a finished product. Builders earn every bit of profit they make in relation to the hassles they endure. You


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“Reality Based” Real Estate Investing wouldn’t believe the time involved to complete a project until you actually do one yourself. A remodel looks a lot easier than it actually is. If you want a list of excellent contractors I would be happy to share the names and numbers of the good ones I used on my project. You also need access to capital for a major project. Most banks will not lend you money once the collateral is severely impaired, a house move for example. How can a bank have any security in a house that is on a trailer? Under capitalization will kill your project and could put you in bankruptcy. I have/had credit lines in place so that didn’t happen to me. Make sure you are well financed.

Second Home/Vacation Properties: If you have the time to enjoy a second home/vacation property then I’m in favor. Many people fall in love with the romantic notion of a second home. I spent many weekends at my grandparent’s cabin in the summer of my early youth. I have some of the best memories of my life from this time period. My grandfather and I caught an 18# 13oz northern pike in North Sand Lake in Wisconsin. His picture was published in the St. Paul Pioneer Press. This is just one of hundreds of memories I cherish. To this day, I still think about the lake almost daily. What a wonderful gift it is to have these memories. My grandparents went to the cabin every Friday and returned on Sunday. Part of every weekend involved a little work, such as mowing the lawn, cleaning the beach, painting the dock, etc. In the beginning of the year you have to open the cabin and then winterize it and close it down at the end of season. You have to put the dock in the lake then take it out of the lake. If you have a boat, you have to do the same thing with it and the boat lift. I guess what I’m trying to remind you of is the level of work. You are maintaining a second home. If you are only going to visit the cabin a few times a year, then most of your time at the cabin will involve working on the cabin. How much fun is that? I know of some individuals and family members who purchased vacation property together as a family partnership. They allocated the weeks amongst themselves. This has worked out well for them. The problem with partnerships isn’t in the beginning but rather when people’s goals and situations change down the road. Make sure you have an exit strategy in place in advance that deals with all the scenarios which may occur. You want to pre plan so there are no surprises down the road. After having done a reflection on the actual amount of time I have available, I have determined that it would be wiser for me to take a few vacations at resorts and actually focus on fun activities rather than on the cost and work associated with actual ownership. In my case, this is not only cheaper, but maximizes my time for enjoyment. This also gives me the flexibility to try different lakes, communities and lodges. If I had a specific piece of property, then that would always be my destination. My preference of not owning a property allows me to have some variety.


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ADVANTAGES OF OWNING A SECOND HOME OR VACATION PROPERTY You have a piece of paradise to call your own. Vacation properties close to the cities have continued to appreciate. As baby boomers increasingly retire, it is projected that they will continue to seek out these properties. Satellite communications and cell phones have made these remote locations accessible. The demographics favor this type of property appreciating into the future. A slight twist on only a second home might be to purchase a time share or a big block of vacation points from some of the time share creators. On the secondary market, these properties are often resold for a fraction of what they originally cost. Typically, timeshares are sold in either specific time blocks where you own a specific week each year or as blocks of points that can be used to reserve weeks based on availability. Obviously, you are able to reserve more desirable weeks if you have more points to spend. Ebay is a great source to find resale timeshare units and the aggregation of resale blocks of points. If I were to purchase something like this, I would buy high season in a desirable location like Orlando. Regarding points, I would want a large enough number of points within a recognized trading system like RCI International. This type of approach gives you some flexibility and you might be able to be use them as gifts for business associates or relatives. DISADVANTAGES Realistically, You are probably not going to use a second home as often as you want. You are probably going to spend a lot of money maintaining this type of property. Don’t forget that there is the mortgage payment, taxes, insurance, furnishings, and any other services that you wish to contract for. If you pay cash, you have the lost opportunity cost of what the cash could have done if deployed in an alternative investment. Do a cost vs. benefit analysis. Look at what it will cost you over an anticipated holding period of time. Add up all the costs. Pick an anticipated appreciation rate. Compare the two numbers and see how you come out financially. Also, look at your current ability to get away and use a cabin. Why do you think that will change in the future? If you are purchasing with the intention of the family visiting the cabin together, consider the reality of that when you have teenagers. That is when my grandparents sold their cabin. The cabin maintenance was getting to be more work than they wanted to do and I was working in the summers instead of hanging out at the lake.


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“Reality Based” Real Estate Investing If you go the time share/points route, just remember that there are annual costs that you have to pay each year. If you do this, always look to the resale market first as you may save 50% or more off of what the developer is selling them for today.

Tax Forfeited Land Or Buildings: I’ve purchased property this way. Unfortunately, It didn’t quite work out as planned. Be very careful. I would only suggest this if you are able to get a deep enough discount in price to warrant the risks involved. You will have title issues that need to be cleaned up. Plan on it. At the risk of being redundant, property may very well be conveyed with title issues. You may also have property issues such as lead based paint, mold, maintaining existing retaining walls, weed control, and problems obtaining adequate insurance coverage. This type of investment is not for someone who doesn’t have the time, patience, and cash to resolve all of the above problems. REMEMBER, the previous property owner felt it was better to let the property go for back taxes than sell it outright. That should be your first CLUE that something may be wrong. It could be that the property had too many liens against it or it could be something specific to the property. Caveat Emptor – Latin for buyer beware. It is easy to start the investigative process and see what properties might be available. You can call each of the counties where you might be interested in buying property. Each county publishes a list of properties that are currently for sale and also a list of properties that will be sold at their next auction. Property auctions are fun to attend. If you want to see people’s competitive nature in action, especially as it overrules prudent investing, then you should attend an auction. I plan on attending again just to see the 2008 mindset of the bidders.

ADVANTAGES OF OWNING TAX FORFEITED LAND OR BUILDINGS You are able to buy properties at an auction, directly from the county, or some hybrid method which generally doesn’t get the full public exposure as a regular listed property. Competition should theoretically be less. If you do your due diligence, you CAN get a deal.


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DISADVANTAGES You will most likely have to commence a court proceedings called “quieting the title” in order to be able to resell the property and establish your claim to the property. Did you know that federal laws trump state laws? Did you know that the State of Minnesota only gives a 60 day notice to all creditors when they take back a property due to tax forfeiture? Did you know the IRS requires a 90 day notice and that if they aren’t given the 90 day notice their lien remains intact? This means that their lien is not extinguished by the state proceedings. I DIDN’T KNOW IT EITHER!!! Be very, very careful if you are buying tax forfeited land. Learn from my mistake. I purchased two lots directly from Dakota county that were sold as tax forfeited land. I did my homework but I still got into trouble. I had a title search completed on the property prior to the purchase. I had two attorneys review the title search-the head attorney for the title company owned by a large real estate firm in the Twin Cities and a private practice attorney who I hired to quiet the title. Both attorneys assured me that I could go through a court proceedings called “Quieting the title” for a few thousand dollars and be in great shape with my title. Quieting title is the legal proceeding that clears the title. Unfortunately I was given bad advice from both of my “experts”. Neither of them understood the ramifications of the IRS lien from the former owner. Ultimately, I had to settle someone else’s tax lien against my newly acquired lots. Imagine how happy I was to pay someone else’s tax bill. It took me two years of negotiation to settle the previous owner’s $15,000 tax bill for $7500. My opinion from this experience is that the IRS is not the kinder/gentler agency they portray themselves to be. They are tough. There are other risks, too, such as insurability. Ideally you’d like to get a copy of a CLUE report. This report stands for Comprehensive Loss Underwriting Exchange. It is a national insurance industry database with more than 40 million personal property claims. If the property you are interested in has had lots of claims, you may find it almost uninsurable at conventional rates. The problem is that the seller has to order the report. That makes it real hard if the property is tax forfeited.

Other than your own due diligence, these properties are often sold “as is” with limited to no disclosure from the seller. The Latin term “Caveat Emptor” i.e. “buyer beware” best describes my advice for you. I recommend you triple check the title. I double checked it and it wasn’t enough . Due to the nature of the title and way that the purchase takes place, you generally have to pay cash for the property.


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“Reality Based” Real Estate Investing This is yet another reason why it is wise to have a sizable line of credit.

Foreclosures: Last year I purchased my first foreclosed home directly from the bank. It turned out to be a great deal because the lender in third position did not redeem their position. This left a lot of equity in the property. It is very rare that a property will have a third position lien. In fact, in this case it was unintentional and due to a mistake being made by the title company that had closed the loan on behalf of the inadvertent third position lender. Foreclosure investing can be done profitably if you are very familiar with the market and the area where the home is located. Because I have lived in the Twin Cities my entire life and have sold homes in the metro area since 1986, I am very well aware of the market conditions and current valuations. I consider myself an expert. Recently, I have seen some very good values on foreclosure auction properties and foreclosure properties being sold on the MLS. These two avenues might be where you want to concentrate if you like this kind of investing. ADVANTAGES OF INVESTING IN FORECLOSURES You are able to buy property for less than it is worth. Isn’t this how it is supposed to work? We, of course, wish it was but we know it’s not always the case. Most of the time you pay retail, which is really just fair market value. Buying for 60-80 cents on the dollar is wholesale investing. Most banks put their inventory of homes on the MLS and let the ultimate price be determined in the free market by supply and demand. The situation where I bought the single family home I own directly from the bank was an unusual situation due to unique circumstances. Generally, you will get your best deals in a slow market where the property needs some work. Don’t expect to get huge discounts like you see on late night TV. On average, you might expect to achieve a 5-10% discount. In some cases there will be no discount. No discount is available if the home is in decent shape in a high demand area. For example, in Edina we have foreclosures. We also have a fairly vibrant market in spite of the overall real estate market’s slow down. In this example regarding Edina, expect any discount to be small to negligible. Foreclosures are hard work for a number of additional reasons. Pre-foreclosure properties can be a better deal. Finding these properties is to your advantage. The key is finding them and then buying them from a motivated seller. Most people won’t do the work and will pick an easier form of investing. This means less competition. Are you prepared for the leg work to find these potential sellers? In the Twin Cities we have two legal papers, Finance and Commerce and the St. Paul Legal Ledger. Both publications publish pre-foreclosure proceedings. In some cases, they only publish the property’s legal description, not the actual address or phone number of the


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“Reality Based” Real Estate Investing homeowner. You will need to figure out those pieces of the puzzle and it takes time. Then you need to drive by the property, assess the neighborhood and contact the homeowner if you think it is worth it. There is a service called Realty Trac (http://tinyurl.com/2jh66u) which publishes foreclosures and also Foreclosures.com (http://tinyurl.com/yqhxq3). These services offer monthly subscriptions and provide more information about the property. Another resource I’ve found is http://www.foreclosureforum.com. This site will list each state’s foreclosure laws and hosts a bulletin board that has useful information. DISADVANTAGES Just like with tax forfeited land, you need to do a lot of due diligence on the property itself. If you don’t perform adequate due diligence, you may find yourself with a bad property, a property with title issues, or both. In Minnesota, we have a 6 month redemption period for the homeowner of their primary residence. This means that the owners of the home can stay in the property for six months after the sheriff’s sale has occurred. How do you know in what condition the people are going to leave the house when they vacate? They may blame the bank for causing their problem. They may vandalize the house. They may take appliances, light fixtures and the copper plumbing. For these reasons and others, I would only buy a home from the seller or from the bank after the redemption period has ended. Another angle involves buying the foreclosed mortgage itself directly from the bank at the sheriff’s sale. In this case, you have assumed the banks position. At the end of the redemption period you will own that property. You are bearing a lot of risk during the redemption period regarding the status/condition of the underlying house. I want that risk to be the bank’s risk, not mine. I once sold a home for an investor who had purchased a defaulted mortgage. He foreclosed on the property and I was selling it for him. The former owner would come back and take things out of the house such as cabinets, appliances, etc. One day when it was approximately -20 degrees, the former owner broke in and turned on the water pump in the basement. In short order he had created an ice skating rink within the home. This occurred on a cul-de-sac in Lakeville, Minnesota. Do you know that the other residents on the block didn’t see a thing? Amazing isn’t it? My client turned the damage in for an insurance claim. Do you know what happened? The claim was denied because he had the wrong insurance. A regular policy does not cover you if the home is vacant after 30 days. This investor found out the hard way. Almost every home sold through the foreclosure process is sold in “As Is” condition.


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“Reality Based” Real Estate Investing This means you don’t know the history of the property. It is very possible that there is something about the house that is deficient or dangerous. For example, it could have mold, lead based paint, asbestos, or have been a drug manufacturing house. A methamphetamine house can cost you an unbelievable amount of money as you may have to replace the plumbing, carpet, drywall, etc. Avoid this type of property at all costs. Homes built before 1978 may have lead based paint issues. Many new stucco homes have mold infiltration problems that can cost you hundreds of thousands of dollars to remediate. PERFORM YOUR DUE DILIGENCE BEFORE YOU BUY THESE HOMES. My opinion of foreclosure investing when you deal directly with the owner is that you are taking advantage of someone else’s misfortune. In order for you to gain equity, you have to pay the owner less than the property is worth. You could make the argument that you are the only one willing to help them and you should be compensated for your risk. For me, it feels like you are taking advantage of someone when they are at their most vulnerable point. It isn’t a “feels good” place for me to invest, especially if you are dealing with individuals in dire straits. There may be a mental illness, chemical dependency issues, extreme medical hardship, or unemployment issue that these families are dealing with. When you work with banks on their foreclosed inventory it is a totally different experience. When banks sell to you it is one business dealing with another business. That type of foreclosure investing is perfectly ethical in my opinion.

Short Sales: Short sales are becoming more popular today. A short sale involves a lender and the homeowner working together to get the home sold rather than have it end up in a foreclosure. Usually what happens is the lender agrees to take less for their lien/mortgage. They agree to sell at a discount, which then allows the seller to avoid foreclosure and actually sell the house for what it is worth in the market at that current time. Lenders sometime prefer short sales over the alternative which is foreclosure. Remember, a foreclosure involves a redemption period and risk to the property. Banks know that if the market value is less than the mortgage balance, it isn’t going to improve with a foreclosure. The bank will have to wait until after the foreclosure process is completed before the lender would be able to liquidate the property. Why not shave six to eight months off the time line if the net cash results are going to be the same or better? Homeowners may prefer to initiate a short sale so they don’t have the foreclosure on their record. As a general rule, a foreclosure will greatly limit or even eliminate your ability to get financing for at least a two year time frame. Most foreclosed homeowners would like to be a homeowner again. A short sale shows a willingness to work with the lender to come to a solution. This may be viewed more favorably by a future underwriter. What many homeowners don’t fully understand is that they may very well have a tax liability based on the amount of mortgage debt forgiveness. If you are a homeowner


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“Reality Based” Real Estate Investing contemplating this, talk to your tax and legal advisors first. They may suggest a foreclosure instead. Because of the mortgage and foreclosure market that we are experiencing in 2007 & 2008 legislation was recently passed. The law is called the Mortgage Forgiveness Act-H.R. 3648. This significance of this law is HUGE. The new law temporarily waives the tax liability on mortgage forgiveness that has occurred from the beginning of 2007 through the end of 2009. This provides an incentive to the homeowner to pursue a short sale vs. a foreclosure with their lender. This should help stabilize housing values. The bill also extends the tax deduction for mortgage insurance premiums through 2014. ADVANTAGES OF BUYING HOMES SOLD THROUGH SHORT SALES As an investor, you have two motivated sellers-the bank and the homeowner. Generally, you will get to purchase the property at a slight discount to the actual market value. Motivation regarding price really just depends on how each party to the transaction views themselves and their bargaining power at the time of the offer. This is in conjunction to the overall prognosis for the real estate market on a going forward basis. DISADVANTAGES When you make an offer during a short sale, you don’t know the bank’s bottom line for a period of time. You make an offer, the seller presents it to the bank, and the bank decides how much of a loss they are willing to accept. You may end up writing lots of offers and doing few transactions if you are out to steal each property. Banks aren’t going to just roll over and let you stick a knife in them.

Buying Homes On EBAY: EBay actually has real estate for sale. Ebay has it all: houses, land, commercial properties, time shares and unique properties. I have actually bid on some time shares and time share points unsuccessfully. If you want a timeshare, you might want to look here. I would be very, very careful when buying and selling other types of real estate. You really need to see and inspect what you are buying. ADVANTAGES OF BUYING REAL ESTATE ON EBAY Only consider this if you are buying what you know, that is your state, which is your area of expertise. You might get a discount. You might get a building that has cash flow. You might find a motivated seller.


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“Reality Based” Real Estate Investing DISADVANTAGES Initially I would ask “Are you crazy?” If you are going to buy property that is out of state, you are really asking for trouble. Realistically, what are the chances that you are lucky enough to have found an overlooked opportunity that nobody locally knew where the property is located has recognized the value? Wake up and smell the coffee. Do you really believe that somehow you are able to see value where others within that specific community have not? Communities across the US are valued differently. When you compare values relative to where you live, you are assuming all things are equal. They are not. You have no idea what the local economy is like, what the other real estate values are, what is required of you as a landlord, what structural or non structural issues may be present-such as lead paint or mold. Also, you will need to hire someone to manage the property for you which is an added expense. There is a book called Acres Of Diamonds. Let me drill down on that book’s salient message. It talks about how you need to look for happiness and opportunity where you are today, and overcome the urge to become restless and seek it elsewhere. Isn’t that a great message? Think how much happier we’d be in our lives if we just stopped believing that happiness lies in the next county, state, job, career or a different significant other. In essence, the grass isn’t always greener on the other side. It is a great book and a very short read.

Rent To Own/Lease Options: Some gurus have recommend this as a way to get above average market rent for your rental property and eliminate negative cash flow. They feel it will endear the tenant to your property. I have yet to see this idea really work in practice. Most tenants rent with the intent of being a tenant. They seldom view your rental property as the house that they will buy someday. I think the investment gurus who recommend this are really just trying to sell books based on theory rather than what actually works in the real world. I have tried to base this book on fact.

ADVANTAGES OF OWN/LEASE OPTIONS You may find a tenant who wants to own a home but for whatever reason the buyer is unable to obtain financing at the current time. You may find that offering rent with the option to buy looks attractive to the tenant. In theory, the tenant will feel more inclined to treat the home better and stay there longer if they believe that one day they will call the property “home”. The tenant may also agree to pay a higher than market rent for the ability to purchase the home in the future at some


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“Reality Based” Real Estate Investing pre-agreed to price. Most tenants will never exercise their options for a number of reasons. This means you are able to get a higher rent during the lease period for a perceived benefit that never materializes, so the theory goes. DISADVANTAGES You will have transferred the potential appreciation to the tenant by agreeing to sell the home to them at a pre-arranged price. A lease option may impede your ability to sell the home in the future because you are stuck in the option term and conditions. You are giving the tenant a certain amount of control over your property depending on how the option is written. Most property owners don’t want to leave money on the table and will instead set the option purchase price beyond what the property has the likelihood of appreciating at over the option period. Most tenants aren’t dumb. Eventually they will figure out that the option price is over priced. When they figure this out, you will have an angry tenant that legitimately resents you as they paid for something that is essentially worthless. They may feel taken advantage of, especially if they have paid a higher amount of rent for the privilege of the lease option provision. I have never been a fan of this type arrangement. There are other variations of this type of arrangement that I feel are better such as giving the tenant a partial credit for rent paid, first right of refusal to purchase if the property is sold in the future, or agreeing in advance to pay a portion of the buyer’s mortgage closing costs. As a general practice, I would always ask the tenant if he/she wanted to buy your building before selling it in the open marketplace. I would never give them a lease option.

REITS/Real Estate Limited Partnerships: This might be something to consider if you want less personal involvement and a greater hands off approach. Always read your prospectus and consult with your financial advisors before making a purchase. All real estate is cyclical and REITS will follow the business cycle. Learn to watch the economy. If you would like to own real estate but not want to own it directly, REITs and Limited Partnerships may be for you. These vehicles don’t historically correlate directly with the stock market. These vehicles are securities that may be either publicly or privately traded. You will need to discuss these investments and their appropriateness in your portfolio with your financial advisers. I will just give you a brief descriptive overview of what REITS/Limited Partnerships are. As we know, real estate in general is very expensive. As such, you may be unable to adequately diversify your exposure to different markets and different types of real estate. Most people don’t have enough money to buy property across the country or across all the different real estate asset classes.


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“Reality Based” Real Estate Investing A REIT in a collective partnership of real estate that may be categorized by style-such as apartments, mini-storage, or office buildings. A publicly traded REIT trades on the various stock exchanges. Generally, 95% of the income from a REIT must be passed through to the investors. The advantage of the REIT is the diversification of the holdings and lack of actual management involvement by you. You will not get a call in the middle of the night to fix a toilet. Also, if the properties generate rents that increase over time, you will receive a larger and larger income. In this sense, these vehicles may keep pace with inflation by returning an increasingly larger income as rents rise. A limited partnership can be small, large, public or private. Limited partnerships by nature are very illiquid. In addition, you are not in control. That is why you are called a limited partner instead of a general partner. Partnerships inherently have more risk. Partnerships may be designed to generate tax losses, income, and/or future appreciation. Typically, these vehicles are expensive to create and run. Before 1986, they were very popular. During that time period, they were primarily bought and sold for the tax losses they produced. The Tax Reform Act of 1986 effectively abolished these types of partnerships that didn’t have any true economic viability. Many partnerships imploded and became worthless. Investors lost fortunes. Partnerships have had a bad reputation ever since. Today the majority of partnerships you will find are “all cash” or lightly leveraged partnerships.

Options On Real Estate: Many large parcels of developable land are initially controlled by options. A developer will agree to buy a parcel of land at a certain price subject to certain terms and conditions. Exercise of the option may be conditioned upon such things as getting a certain number of lots approved, changing the zoning or the ability to develop and bring utilities into the site. In the event the developer is unsuccessful, they may let their option expire or renegotiate their purchase price to reflect what they were able to accomplish. You don’t typically see options on residential type buildings. They are used more often in an offer for a redevelopment site regarding a commercial building or buildings. A much more common option involves commercial leases. You may see an option within a commercial lease that allows the tenant to continue his/her lease based on some prearranged formula. Depending on which way rents move, this could be a very valuable asset to the tenant and a liability to a landlord. If you do purchase a commercial building you will want to review all leases, paying careful attention to any renewal terms and conditions that might give the tenant an option. Options are an advanced strategy. It probably isn’t going to be the first thing you do when creating your real estate empire. Creating an option involves finding a seller and giving them some money, generally non refundable consideration, for the right to purchase their property on some agreed to terms and conditions over a certain time period. An option is generally unilateral in that you, the potential buyer, has the option to purchase, whereas the seller has the obligation to sell under previously agreed to terms.


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“Reality Based” Real Estate Investing Normally, after the expiration of the option time period, there is no binding obligation on either party. Options can be especially useful for a developer to get control of a piece of property in order to rezone it or get a project approved before purchasing the land. If they are unsuccessful in gaining approval, then they don’t exercise their option and lose their consideration and any developmental and engineering costs incurred. The grantor of the option is able to get some non refundable option money in advance, and possibly a higher price for their land/building because they’ve reduced the risk to the developer. It can be a win-win for both parties. If you are the developer, it can give you a huge leveraged return on your option consideration money. There are many books written specifically on this topic. I simply wanted to make you aware of the concept and how it works.

Builder Close Outs-An Under Appreciated Opportunity: Publicly traded companies have to satisfy Wall Street on a quarterly basis. If you are able to take their inventory off of their hands, you will be doing them and yourself a favor. It is a win-win for everyone. The best time to negotiate with publicly traded builders is the last 30 days before their quarterly reporting period ends. You will get a great deal if the builder is sitting on a number of vacant spec homes. New homes will have all the warranties we discussed earlier. The risk to you is that you may be unable to rent them at an acceptable level of rental income.


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Chapter 3 GEOGRAPHIC & DEMOGRAPHIC CONSIDERATIONS WHO-WHERE-WHY!

“LOCATION-LOCATION-LOCATION” OK-you’ve heard that adage ad nauseam. Well, now you’ve heard it again. Yet this truism defines whether you will have a pleasant and profitable experience as a landlord, a mediocre experience, or a downright unpleasant experience. Let’s break out each of the three “location” definitions as I define them: Location #1-Crime, Location #2-Schools, Location #3-Amenities/ease of ingress and egress. I am going to include an additional fourth location because I think it is important. Location #4 deals with the over all age of the community housing stock. Ideally you want to find a property that combines the best attributes of each of these categories. Let’s break them down.

Crime-Location item #1


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“Reality Based” Real Estate Investing You can do a lot of research right from your computer and phone. But the first thing I would do is drive by and through the neighborhood in which you are considering making the investment. Take a note pad and write down some of the addresses of the properties that are nearby. For example if there is a large apartment building on the corner, or multi family building/unit in close proximity write the address down for further research. When you get back to your home or office, call the police chief that services that area. You can give them the address of the properties you’ve selected and ask about the number and type of police calls that have been called in from that address over the past year. You can also discuss with the police the neighborhood itself to find out about registered group homes and whether any crime or registered offenders may live nearby. Many local police websites also provide a lot of information about what is happening regarding that specific city or neighborhood. Here is the Minneapolis site http://www.ci.minneapolis.mn.us/police/ . Here is the St. Paul site http://www.stpaul.gov/depts/police/ . Always remember that tenants that don’t feel safe will move. This, of course, assumes they have the ability to move. Even if a tenant isn’t initially diligent in their crime research, it won’t take them long to figure it out once they’ve moved into your property. If the crime rate is high, they won’t renew their lease. In fact, they may break their lease. This means more turnover and greater expenses coupled with a larger time commitment from you. That’s why I stress buying in the most desirable location that you can. Another resource is The United Way. They have some helpful data on their website at http://www.unitedwaytwincities.org. They call them profiles for Minneapolis Neighborhoods. These profiles have been compiled from the U.S. Census Bureau of the Census and from the Minneapolis Police Department. This may aid in your research of various demographic data. Next I am going to reference some resources for the State of Minnesota. One is at http://www.mncriminals.com I found this site extremely interesting. You can register for free and then input someone’s name into the data base. If that person has been convicted of a crime in Minnesota it will show up. This includes DUI’s. The greatest part of this service is that it’s free. When you are doing your tenant screening you may want to start here first. I assume you will be doing full criminal and credit background checks-more on that later. This is a first step that you can take before spending the money to do the full blown search. If you want to check out registered sex offenders, check out http://www.familywatchdog.us and http://www.corr.state.mn.us or call them at 651-3617200. For safety reasons, a tenant will want to live where they perceive it to be safe. The reason a specific property you may be interested in is under priced may be due to who is living in close proximity. Find this out before you make your offer. The seller and the seller’s Realtor are under no obligation to disclose this to you. I showed a client a beautiful duplex in Northeast Minneapolis about 10 years ago. It was at least $25,000 under market. We soon discovered why. When we went to the basement, there was gang graffiti sprayed on the wall. When we went outside to view the exterior we were greeted


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“Reality Based” Real Estate Investing by terrible epithets from an angry youth who spit in our direction after he was finished berating us. Besides having this special human adjacent to this duplex, his property was in disrepair. Either you had an absentee landlord who just didn’t care about his property or you had an owner occupant who didn’t care about his investment. Either way, we chose not to invest there. We moved on. Again, life is too short. You may not know that registered group homes and facilities sometimes are single family houses and duplexes. This actually happens quite frequently. These homes provide housing for people with various needs. Call your prospective city offices and ask for the addresses of the licensed facilities and what type of licensing they maintain. You will be surprised to know that one might be blocks from where you are living. These buildings don’t necessarily cause problems. I have positive and negative stories about these properties. Just make the call to the city and draw your own conclusions based upon the clientele that is being served at the group homes nearby your rental property.

Schools-Location item #2 All things being equal, a person will choose to send their child to the schools where they believe they will get the best education. Communities where the school results are superior will be more desirable. Supply and demand then will dictate that real estate will cost more within these areas. Think about this when buying a single family home. A single family home as a rental property will very likely attract a tenant that has children. There are certain communities within the Twin Cities which tend to consistently show test performances at very high levels. It should not be a surprise that these particular communities also have the highest priced real estate within the metro area. Remember that part of your strategy when buying real estate is to have an exit plan. A strong school system will always be desirable regardless of the other events affecting the overall housing market. Here are some education rating resources. The first one is the Minnesota Department of Education http://education.state.mn.us/mde/index.html . The department publishes the math and reading test results for the schools within the state. You can use their reports to see which communities and schools are producing the best test results. Additional resources include The US Department of Education Institute of Education Sciences http://ies.ed.gov/ and a publication called Schoolhouse Magazine http://www.schoolhousemagazine.com . Another key factor, often overlooked, is demographics. The specific demographic you should concern yourself with is the age of the population within your city or area of interest. On the surface, you might assume that it doesn’t matter. Let’s dig a little deeper. Most communities will fund the majority of their school improvements through a bond issue. Cities place their bond referendum issues on a ballot and the citizens of that community have to vote “yes” or “no” since they are responsible for paying for the bond through an increase in property taxes. If a community is an older community with


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“Reality Based” Real Estate Investing older residents, they may not see the need to pass a bond that improves the schools. This happens for a variety of reasons such as: residents no longer have children in the school system and don’t see how it will benefit them, they are on a fixed income that they don’t feel will allow them to make the increased tax payment or they simply don’t think it is necessary. Regardless of their reason and validity, a vote against a school bond referendum is a vote against the inherent desirability of that community. I am not saying schools should have a blank check to do whatever they want whenever they want. At the same time, having the best possible education for our entire population is the most important thing we can do for the good of our society. If a bond referendum allows children to obtain a better education in an ever competitive world without borders, then we should give it very strong consideration. Unfortunately, voting on bond issues for items like schools tends to follow a correlation with age and familial status with children. You may want to visit the State of Minnesota’s Demographic center at http://www.demography.state.mn.us/Census2000.html and do some research. If the community you are considering investing in has a large congregation of older folks or individuals without children, it might be reasonable to expect some resistance to passing bonding issues. This will impact your ability to attract tenants and will affect the resale of the property. Once a community is perceived as not being able to provide an education that is equal to that of other surrounding school districts it will start to decline. From a self serving standpoint, we have already outlined the benefits of investing in communities with strong schools. An investment in our children’s education is an investment in the future of the United States and our ability to remain competitive in the world. Think about this next time you are asked to vote on a bond referendum within your own community. Amenities-Location item #3 What attracted you to where you currently live? Was it the low crime and schools? Was it the quality of life amenities such as proximity to shopping, ease of access to freeways or parks and lakes? My guess is that it was an aggregation of factors that involved trade offs on your part. It will be like that for your tenant too. A tenant without children will be more inclined to look for amenities like bike trails, night life and entertainment. These are less important once you are preoccupied with raising a family. Look at the amenities in the community in which you are thinking of investing. If you were a prospective tenant would your needs be met? Think about the property you will purchase and the likely tenant you will find for that specific property. For example, if you purchase a single family home, condo or townhouse in a 2nd tier suburb which is essentially a bedroom community you will most likely attract a family, older tenant or possibly a divorced parent that is sharing custody of children. Will your property accommodate the needs of this group? On the other hand, if you purchase a condo downtown, you will attract a younger and perhaps childless tenant. Think about what type of individuals you would prefer to have as tenants when you go


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“Reality Based” Real Estate Investing about selecting an investment property. You don’t want to purchase a property that doesn’t have enough demand based on the demographic from which you’ve chosen to market. Areas that appear timeless in attractiveness within the Twin Cities are the neighborhoods surrounding our city lakes. They will always be desirable and properties around them always will carry a premium. This isn’t the best for your initial cash flow, but it might give you comfort knowing that valuations will more than likely be maintained. Ingress and egress to your rental property neighborhood are of value to both you and the tenant. If a property is in a difficult to find or distant location, you will have problems attracting a tenant. Ideally a property will be located where it is easily accessible and at the same time has a close proximity to the amenities listed above.

Age of Housing Stock-Overlooked item #4 The age of the surrounding housing stock is too often overlooked in the location-locationlocation analysis. Consider for a moment why it might be important. In general, older housing has a larger amount of obsolescence. This can lead an area of town into rapid decay if homeowners are unwilling or unable to maintain a base minimum of standards regarding the condition of their housing. Declines in value tend to occur more often in the oldest of neighborhoods. Many cities with older housing stock such as Minneapolis/St Paul and certain 1st tier suburbs have instituted a seller required program known as either the truth in housing report or the time of sale disclosure report. The Minneapolis Area Association of Realtors has provided a list of these cities and their time of sale disclosure requirements together with the ordinances at http://www.mplsrealtor.com/Public/Time-of-sale.htm. These ordinances require that sellers have their home inspected when placing their home for sale. The seller’s home must be brought up to a minimum level of repair. There may be “code compliance” issues that need to be corrected. Once these items are corrected, the house receives a code compliance certificate that allows the home to be sold. The intent of the program is to have all property within that respective city to be maintained against a city established minimum baseline. The nice thing about purchasing property in areas that require an inspection and report is that generally the seller bears the cost of this work. Not all communities have this program in place. If you buy in a community where the program didn’t exist previously, and later become a seller when a program is instituted, you will bear this cost burden. This can be a hidden expense that you should factor into your analysis. One thing I have noticed is that improving a piece of property often is contagious. Try to focus on neighborhoods that appear to be well maintained and hopefully have been gentrified or are in the process of becoming gentrified. Gentrified is defined in Webster’s Dictionary as “the process of renewal and rebuilding accompanying the influx of middleclass or affluent people into deteriorating areas that often displaces earlier usually poorer


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“Reality Based” Real Estate Investing residents.” Areas that are not being maintained may be in transition or are transitional. When the outcome of the transition is uncertain, you have a greater chance for profit and for loss. Uncertainty usually brings a discount in current value.

The distance from your home to your property is a Sub component of location I personally don’t enjoy driving for hours on the freeway. My guess is you don’t either. If you have rental properties, you will need to visit them periodically if only to show them to prospective tenants. How much driving are you willing to do in owning and managing your portfolio of property? Are you willing to drive to all ends of the seven county metropolitan areas or would you like the property situated closer to your home? My personal rule is 30 minutes. This means I want to own all my rental property within 30 minutes of my home. There are many opportunities within the geographic range of 30 minutes so I don’t need to travel further unless I want to. I could possibly get better cash flow if I expanded my boundary beyond this range, but then I’d have more drive time. Each of you reading this book will have a different range of acceptability. Some of you may have relatives that live an hour away from your home. If you own property in their community, they may be able to help you with some of the minor duties involved or you may not look at it as burden to drive an hour since you can stop and visit with them when you’re in their town.


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Chapter 4

CORRECT Investment Property Financing Financing can make or break your transaction. How you finance a building will be a major component in determining your profitability. Generally speaking, people prefer to maximize their financial leverage when purchasing a property. This means they prefer to use as little of their money as possible and borrow or finance the majority of the purchase. In an ideal world, this would be fine. In the real world, you need to consider putting something down for a couple of reasons. The main reason to put something down is to reduce or eliminate negative cash flow. The second reason is to have available the maximum number of financing options at the best possible pricing. Here is how it all works together. Lenders aren’t in the business of owning real estate. Lenders are in the business of financing real estate. If you put little to nothing down, lenders run a much greater risk of getting the property back through a default. Because the risk is greater, lenders will naturally charge much more to lend money at 100% loan to value than they would have at 80% loan to value. Sometimes putting something down is simply a shell game of moving money from one property to another. For example, using money from a home equity line of credit on your primary residence to use as a down payment on a rental property still may effectively


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“Reality Based” Real Estate Investing equal 100% financing. The difference is that the new rental property isn’t the property with all the financing or leverage. As of today, Minnesota has enacted some lending laws that prohibit you from obtaining certain low documentation loans and no documentation loans. This new law does not apply to rental property or commercial property. Even though the law may allow them, lenders are reducing, modifying or eliminating these programs. Their availability will be impacted by investors wishing to purchase these loans. Because of all the ambiguity, I am going to focus on full documentation loan strategies.

Residential Vs Commercial Financing If you purchase a four unit building or smaller, you will be eligible for traditional residential financing. I define traditional as the typical vanilla mortgage products offered by most mortgage companies. Traditional mortgage loans vary from the 30 year fixed mortgage to the Option ARM. Your goal as an investor is to coordinate the appropriate matching of the right mortgage product with your intended holding period. For example, if the pricing was better, you might look at an ARM (adjustable rate mortgage) for a building you intended to own for less than five years. If you intend to own a building for many years as a cornerstone in your real estate portfolio, then you might prefer a 30 year traditional amortizing loan. I often see investors making mistakes in selecting appropriate financing. This is another good reason to select a knowledgeable mortgage loan officer and a reputable mortgage broker. I am the President of my own mortgage brokerage company-Venture Development Inc. You can visit us online at http://www.ventureloanapp.com Venture Development is a Minnesota mortgage broker. A mortgage broker has selling arrangements with many investors. Investors are often defined as larger banks or lenders who purchase loans from mortgage brokers. Here are some names of investors you might recognize: Countrywide, Wells Fargo, US Bank, Bank Of America, Washington Mutual and TCF. These and other investors offer wholesale pricing to brokers. Wholesale broker pricing from these institutions generally beats the loan pricing offered at their retail branches. This is largely a function of overhead. The banks that have retail branches have an infrastructure overhead that needs to be factored into their pricing model. This is one reason why mortgages originated at the branch of a large financial institution will have a higher interest rate. The cost of acquiring loans through the broker channel is much less. Mortgage brokers can bring more financing product options to you. Usually, a mortgage broker has access to more loan product choices than a traditional bank, which I will refer to as a captive lender. Having access to a greater availability of financing choices allows you a better chance of making better decisions. You owe it to yourself to talk to someone in the broker channel. Generally, a captive lender is only able to offer mortgage financing products that they are able to sell or create. Working with a captive lender yields fewer mortgage product


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“Reality Based” Real Estate Investing choices. Captive lenders tend to rely on their size and name recognition as their main selling point. In my opinion, this isn’t a selling point at all. In fact, you may not be aware that many of the large recognizable captive lenders that you are familiar with (think about where you do your banking now) have wholesale selling arrangements with brokers like Venture Development. This means brokers can provide financing from the captive lender more cheaply than if you were to go to the captive lender directly. I enjoy competing against the larger banking institutions and beating them with their own money. If you must have mortgage money from a name lender that you recognize, let your broker know that so he/she can accommodate your request. Let’s review the problem with relying on the loan officer at the bank or mortgage broker that has never owned rental property. While these individuals might be competent about how their products work, they can’t give you advice from any personal experience. The same should be said about Realtors who don’t own rental property. How can these people advise you adequately when they don’t “walk the walk”? Think about this long and hard before you select a Realtor and mortgage person to represent you. You need experience to lead you. Let me ask you-would you go to a plumber to have brain surgery? You must work with people that know what they are doing in their chosen field of expertise. Let’s consider a case of the wrong financing and how it might affect you. For this example, let’s assume you are taking out a mortgage on your new rental property. We need to make some assumptions about the available products. Let’s assume the interest rate on a traditional 30 year mortgage is 8.25%. You are also being offered other mortgage products with the following rates: (1) the 5 year amortizing ARM is 7.5%, (2) the 5 year interest only ARM is 7.75%, and (3) the rate on an Option ARM is 2% start rate, with a fully indexed rate of 8%. Which one should you choose? Why would you pick one instead of the other? Here are some guideline questions that might help you arrive at your own answer. Everyone’s situation is different. The answer is “it all depends”. Here are a series of questions to help you make the right decision. First, consider your holding period. If you aren’t going to own the property for 30 years, then don’t automatically consider a 30 year mortgage. We are making the assumption that a 30 year mortgage has the highest interest rate. Next we will look at the other three choices. Choice (1) the amortizing ARM at 7.5%. This gives us a .75% lower rate. Are you very likely to sell the property within five years? If the answer is yes, then this would be a better choice than the 30 year fixed mortgage. Choice (two) is a five year ARM, but you only pay interest, not principal in the first five years. With an interest only loan, you don’t pay anything towards reducing the principal. Why is it a good thing to not pay principal? Let me give you three reasons. First, interest only gives you a lower payment. Would your budget benefit from greater cash flow? Second, you can take the savings derived from the difference in payments that would have paid down principal on an amortizing loan and invest it elsewhere. Here we need to


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“Reality Based” Real Estate Investing make an assumption. We assume that wherever else you invest the principal, it will yield more after taxes than had you paid it down on principal of the loan. For example, one option for your principal might be your IRA or 401K. I often find that many people can’t do it all. Have you ever found that there is too much month at the end of the money? It’s hard to put the maximum allowed into a retirement plan especially when you are allocating dollars into an investment property that might have a negative cash flow. A mortgage with interest only may allow you to find those extra investable dollars. Consider this: the return on your retirement plan is at least your incremental tax bracket from which these dollars are now growing tax deferred. This tax bracket tax savings usually gives you a considerably better return than had you simply paid the principal down on the mortgage. When you pay down/off a mortgage you have accelerated or removed permanently one of your major tax deductions. Third, interest only payments help eliminate/reduce negative cash flow from the investment property. As properties become more expensive, the ability to have them cash flow greatly diminishes. If you make your mortgage payments based on “interest only” you can sometimes overcome or mitigate any negative cash flow. It also allows you to purchase a slightly higher priced property for the same amortizing paymentapproximately 20% more. You might also consider the Option ARM. As of this writing, within Minnesota this product still exists at low loan to values for investment properties only. In the future, this type of loan product may be restructured or eliminated from the marketplace. This product is unique unto itself. It allows you to make your monthly mortgage payments in one of four ways. You get the option of choosing monthly how you want to make your payments. You can alternate your payment choice monthly. Generally, your payment options are calculated based on the following variables: the fully indexed ARM rate based on a 30 year amortization; the fully indexed ARM rate based on a 15 year amortization, an interest only payment based on the fully indexed ARM rate; or the starter rate which WILL result in negative amortization. The starter rate is generally 13%. We need to understand what happens to the difference between the starter rate and the fully indexed rate. The difference in the rate becomes the “deferred interest” or negative amortization. This difference is then added to the back end of the mortgage and your initial loan amount will increase in size over time. Negative amortizing loans have a place in the market despite the bad press they have received. These loans have been used successfully in an escalating or highly appreciating marketplace. They allow you to make the lowest payment possible while owning or controlling a property. These types of loans were very popular in hyper inflationary pricing environments such as Florida, Washington DC, San Francisco and Las Vegas. Many investors in these areas bought property to flip or turnover quickly. When values and appreciation exceed the rate by which the loan is negatively amortizing, you are net net making money. Remember though, that leverage is a double edged sword. When properties are declining in value, you will be losing money much quicker than if you had


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“Reality Based” Real Estate Investing a traditional mortgage since you now have to contend with the negative amortized interest. It is very easy to find yourself upside down” quickly in such a declining market. The best feature of the Option ARM is that it allows you to control your cash flow by choosing how to make your mortgage payment. Imagine the benefit of having payment flexibility if you need to have a property vacant while you rehab/renovate or lease up a vacant building. The key to all mortgage products is to understand how they work and see which one will best fit in with your goals. You may find that you have different financing strategies for different properties all within your same portfolio. This again is why it is so important to work with someone who has the experience and ability to walk you through your financing options. Here is a real life example from my personal experiences. I purchased a condominium in what was to be newly constructed for $175,000 at Emerald Gardens. I put 5% down and waited two years for the building to be completed. I put an additional 5% down when I closed, for a total of 10% down. I bought from the developer’s sales trailer when all they had were brochures and an undeveloped parcel of land. I bought in the beginning so I was able to get some incentives/upgrades for free such as granite countertops and a fireplace. The project was built in four phases. By the time my building (phase 1) was ready to close, they were selling into phase 3. New condominium pricing had increased due to the project’s natural appreciation and also due to increases in the cost of construction-such as labor and materials. Lucky for me, I had a $25,000 profit on paper the day I closed. This “profit” reflects the change in base price and cost of upgrades from phase 1 to phase 3. I rented the unit for about 18 months. In that time period, the building appreciated another $13,000. My investment strategy was to own the unit for just a couple years. Because I intended to own the condo short term, I financed the building with a six month interest only ARM. At the time I did this, the rates on the six month ARM were about 4% and the rates on the 30 year fixed loans were about 5.5%. I was able to take advantage of the interest rate differential of 1.5%. This means I was able to get better cash flow. My cash flow was again enhanced by the interest only feature. I also benefited because the building’s taxes for the first year were based on an assessed value of a vacant lot. Putting 10% down, $17,000, and selling for an approximate profit of $38,000 gave me a little better than 200% cash on cash return. This does not factor in any depreciation benefits or positive cash flow. This doesn’t factor out some of my acquisition and selling costs. Although this analysis is simplified, it is an accurate summation of the transaction. What would have happened if I had taken a fixed 30 year mortgage? My return would have been less. Depending on the rent, I might have had negative cash flow instead of positive cash flow. If I had paid cash I would have only received a 20% return. This demonstrates the power of leverage. Through this example, you can see how the financing can dramatically impact the return on your real estate portfolio.

Commercial Financing


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Commercial financing is generally reserved for buildings that are over four units. This would be the type of financing that you would look at when financing an apartment building or some other form of income generating property such as an office or warehouse. Lenders first look to the cash flows generated by a property for the ability to repay the mortgage. They focus less on the individual or entity buying the building. This is just the opposite in financing units that are four units or less. The residential market focuses heavily on the borrower and the borrower’s ability to make payments. Since commercial financing looks primarily to the buildings cash flow, lenders base their financing on some multiple of rents received. This is called capitalization of net income. I won’t spend a lot of time on this, since I am recommending that you don’t buy an apartment building or any other commercial property. Suffice to say, your choices regarding commercial financing are less than residential financing. You can use a broker or a banker to obtain financing. Most commercial financing is not 30 year financing but rather 10 year financing that has payments based on a 30 year amortization schedule. Fewer financial options add another level of risk of owning apartment buildings. You might not like the financing options that are available to you when your mortgage becomes due and payable at the end of the initial 10 years. Assumable Financing Assumable financing was fantastic when it existed. I could not have bought my initial real estate without the benefit of assuming existing FHA/VA loans. Non qualifying assumable financing was discontinued 1987. Prior to that time, you could assume an FHA loan VA loan without qualifying. All you had to do was pay a $500 fee to do a non qualifying simple assumption. You could have no credit or bad credit and still assume a loan. Here is how a typical transaction would work. You would either put down the cash difference between the mortgage and the asking price or have the seller carry back the difference (their equity) on a seller held mortgage or contract for deed. I purchased a condo and two duplexes by assuming loans and writing seller held contracts for deed. The contract for deed portion of the purchase price represented the majority of the seller’s equity. Unfortunately, this system of assuming mortgages was ripe for abuse. There were individuals who would go out and assume mortgages, rent out the properties, and then let them go into foreclosure. Since these mortgages were assumed as simple non qualifying assumptions of the previous terms and conditions, the assumptions did not provide any release in liability to the original borrower in the event of a default by a subsequent assumption. Imagine if you, as the original borrower, had sold a property on a simple assumption to a person with good credit. Later the person whom you allowed to assume the loan sold it to another person on a simple assumption. What happens if the third borrower lets the mortgage go into default? The default/foreclosure could show up on the original borrower’s credit record since they were never released from any liability regarding the loan.


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“Reality Based” Real Estate Investing Worse yet, if you were a veteran, you could be held liable for a deficiency if the property was sold for less than was recovered from the subsequent foreclosure sale. In addition, you would never be able to get your VA eligibility for a VA loan back, since you had a foreclosure on your record. Since these nightmare situations did happen with great frequency, FHA and VA changed their rules to only allow assumptions based on fully qualifying. Qualifying the new borrower for the assumption granted the original borrower a release of liability. Today, some conventional ARM loans may allow for an assumption, but again only if the new borrower is qualified. An assumption today would only be advantageous to pursue if the seller had an unusually low interest rate. That isn’t occurring much in today’s interest rate environment since rates are still very low.

Contract For Deed Or Using A Seller Held Mortgage Seller held/created financing is where the seller acts as the mortgage company. The seller creates the contract for deed or seller held mortgage based on the equity they have in the property. They agree to accept payment on their equity, with the balance eventually coming due. Normally, a typical contract for deed runs for 10 years or less and has a balloon payment where the balance is due. Rarely will you find contracts/mortgages that fully amortize over a long period of time. Most sellers don’t want to have their equity tied up in payments for much longer than 10 years. Contract for deeds had their heyday in the late 70’s and early 80’s when prevailing mortgage interest rates were double digits. These high rates were a deterrent to selling homes as people either couldn’t or didn’t want to take out mortgage financing. Sellers had to sell on contracts for deed to make their property saleable. This isn’t the case today because interest rates are very low. Today, if you see contract for deed financing offered, it is usually because there is some feature of the property that prevents it from obtaining regular/traditional financing. In other words you own a white elephant. This means you will probably have to sell the property the same way you are buying the property. It may be possible to resolve the issue(s) that prevents the property from being financed under traditional methods in the first place during your tenure of ownership. There are other reasons why a seller may offer this financing. Sometimes you will find sellers offering this financing as an inducement for someone to buy the property because there are few closing costs and no qualifying restrictions beyond what the seller may require. This will attract people who can’t qualify for a traditional loan. This could be trouble. I don’t recommend you sell property offering seller held financing unless that is the only way you can find an acceptable buyer. Most mortgages today have something called a due on sale clause. This means the lender wants to be paid off when you sell the property. In the past, with old (pre 1987) FHA and VA loans that allowed for simple assumptions, you could wrap a contract for deed around existing financing without invoking the due on sale clause. Since almost no financing today allows for non qualifying simple assumptions, selling a property on a contract for deed will allow the mortgage company to accelerate the existing mortgage and call it due.


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“Reality Based” Real Estate Investing Imagine the mess you would be in if you wrote a contract for deed with a buyer and then had to pay off the existing underlying mortgage because it was called due and payable. What if you, the seller, couldn’t pay off the underlying mortgage? At the same time, the buyer who bought on a contract for deed might be unable or unwilling to refinance the property and completely pay off the mortgage. Under that scenario, you’d have a big mess and probably have a lawsuit to contend with. Be very careful before you enter into this type of arrangement. Know the restrictions of any underlying mortgages before you write a contract for deed. Home Equity Used As A Down Payment This is often the first place that people will find the down payment for investment property. There is a famous author who has written many recent real estate investing books and looking to your home equity for cash is one of his main premises. His premise is that the equity in your home is not working for you. His plan: find an investment opportunity that can be purchased with a positive cash flow, break even or negative cash flow that is offset by a corresponding amount of appreciation. If you do this, you will now have your dead equity working for you. You will have the aggregate value of two properties appreciating instead of one. Home equity used in conjunction with an investment property purchase can effectively create a 100% loan to value. You might take out a home equity loan and use the proceeds for a 20% down payment on an investment property. The 100% financing is just spread over two properties, the home equity loan at your primary residence and the investment property. It is often much cheaper for you to have a blended rate of two mortgages. The interest rate is cheaper if you only finance an investment property at 80% or less. Financing the investment property with 100% financing is possible but you will find the interest rates will be higher and the program’s options will be greatly restricted. Either way, you are aggregately obligated for the total amount of debt. You might want to focus on the combination of debt that offers you the cheapest blended rate. This will ultimately require that you don’t leverage all the financing against the investment property. Using Your IRA As A Source Of Capital You can use your IRA as a source of investment capital for an investment property purchase. There are many restrictions and more than a few caveats when you look to your IRA for financing. Here are some of the basic requirements: you are not able to use the property for your own use and enjoyment and you are prohibited from acting as the property manager of the property. You will need to hire someone to do this for you. These restrictions will involve additional costs which in turn will lower your investment return. When your IRA buys an investment property, it must either pay all cash or use non-recourse financing. Most available non-recourse financing for an IRAs is capped at 50% loan to value. This means if you put down $100,000 you can only obtain financing for $100,000. Non recourse financing is defined as financing where the property will


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“Reality Based” Real Estate Investing stand as sole collateral. You are able to give the property back to the lender without any recourse. There are very few lending outlets for IRA financing. Another pitfall is in finding a custodian that will allow the IRA to hold title to a property. You won’t find any of the major brokerage firms or name banks willing to do this. There are the two large custodians that do specialize in this type of transaction: one is Pensco and the other is Entrust. There may be others, but these are the two largest at the time of this writing. To begin the process, you would roll over or transfer an existing 401K or IRA from your existing custodian to a new IRA set up with the new custodian. From there you would begin your property search. Remember, the IRA ends up buying the property and goes into title. As you can see, you will need a rather large IRA to buy property. In addition, all expenses for the property need to pay out from the IRA. This means you will need enough cash left in the IRA for emergency or unplanned expenses such as a new roof or furnace. One advantage of buying in an IRA is diversification. You will have access to a typically non traditional asset class within a retirement vehicledirect ownership of real estate. I personally think you can diversify into real estate in better ways. If this sounds too complicated and you want another alternative, consider buying REITS or limited partnerships with your existing IRA at your existing IRA custodian. This is less complicated and might offer better diversification. Regarding any/all securities and IRA’s, make sure you consult your own set of financial advisers to see what your options might be and which would be most suitable for your situation. Credit Cards/Lines of Credit-Secured & Unsecured When you first start investing in real estate, you will probably be under capitalized. Not everyone has excess cash in the bank. How can you get more capital when you have very little to start with? The answer may involve creating it through credit. This sounds unconventional, but you need to obtain all the credit you can when you can. This means setting up lines of credit and opening credit cards when you don’t need the credit. When are you most likely to be approved for credit? Do you think it is when you really need it or when you really don’t need it? The answer is when you don’t need it. If you are employed, you will qualify more easily than if you are self employed. Lenders believe a pay stub and W-2 provide greater income stability. Somehow lenders equate a W-2 salaried employee with stability. I guess they’ve never heard of employment at will. Aren’t we all self employed to some degree since we work in an environment where you can be let go without cause? It doesn’t make you a better credit risk by being an employee; it’s just how the credit system works. Consider applying for credit when you look your best financially. This might be after a large income year or when your existing ratio of debt to income is less. Credit is granted based on a snapshot in time. Depending on the type of credit that you obtain, the issuers generally can’t take credit back once it’s been granted.


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“Reality Based” Real Estate Investing Credit is useful for a number of reasons. You can quickly take advantage of an investment opportunity when it presents itself. Contrast this with having to go through underwriting or qualifying. It is possible that sometime in your life you may run into an extended period of bad luck such as an extended illness or unemployment. If this happens your credit can carry you through until things turn around. Life is full of ups and downs. Be ready for the downs if they arrive. This is part of having a plan B, plan C and plan D. Think about the banks, insurance companies, and many of the wealthiest individuals in the world. What do they all have in common? They use debt constructively. They earn more on their debt than it costs them to acquire the debt. Learn to love the right kind of debt. It’s all about the constructive use of leverage and earning more on your debt than it is costing you. Many of you were taught to pay cash and that credit is a bad thing. Challenge yourself to explore this paradigm shift regarding credit. Remember that if you act like everybody else, you will end up like everyone else. At retirement age, fewer than 10% of people are financially independent. Partnerships Can Be The Most Expensive Form Of Financing You may have heard the joke/cliché: Q-What are the two happiest days in a boat owner’s life? A-The day he buys his boat and the day he sells his boat. The same could be said about forming a real estate partnership-the day you form one and the day you subsequently dissolve it will be your happiest days. Here’s another cliché that you should remember with a partnership: A partnership is a ship you don’t want to sail. Still, if you must consider a partnership, let me give you a few things to consider in advance of forming the partnership. You need to plan out the dissolution of the partnership at the beginning of the partnership. Working through the unpleasant questions upfront will save you time and energy later. After reviewing the questions and scenarios with your potential partner you may discover that you shouldn’t team up. Besides avoiding the hassle factor later, you will be able to walk away as friends. A partnership is like a marriage-the better communication and understanding the better the marriage. We know the success ratio of marriages. Partnerships fail for exactly the same reasons-poor communications, resentment, divergent goals and growing apart. Besides being a lot of work, a partnership is also the most expensive form of financing. Think of a partnership as borrowing money at a rate of 50%, since you are giving up 50% of the upside in the property. Yet because most decisions are made together you are really doing 100% of the work. A partnership usually requires a division of duties. Herein listed are some of the problems you will encounter. Without a doubt, one partner will feel they bring more to the table or are shouldering more of the duties and responsibilities. Overtime this will bring out resentment. Most decisions need to be made jointly because you are partners. What happens if your opinion about a potential tenant, an improvement, or the property are completely divergent? How do you go about coming to a consensus? What if one partner wants to sell and move on? How do you divide up the properties? How do you


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“Reality Based” Real Estate Investing balance the equity and properties when there are an uneven number of properties with disproportionate equity? What happens if there is a disagreement over who shall get which property when they are ultimately divided? Did you set up a partnership agreement in writing in advance of buying property settling these issues and/or have a provision for arbitration or mediation? If one party has to buy out the estate of the deceased partner, is there a buy sell agreement in place? Is the buy-sell agreement funded with life insurance or other assets? Are you both on a joint bank account? Does the bank account have a line of credit which you are obligated to repay, but where either of you can sign a check? What if your partner gets sued and loses and/or declares bankruptcy? What if there is a lien or charging order from some entity that result in the liquidation of your partner’s portion of the partnership? What do you do when your partner has chemical dependency issues that are now affecting your partnership? I encountered many of the above problems when I bought my first three rental properties with another Realtor and his wife. Luckily, I insisted that we sign a partnership agreement in advance before we became property owners. There was a provision requiring mediation if we could not come to an agreement amongst ourselves. We almost went down that road until the wife of my Realtor friend stepped in and encouraged her husband to honor a previous agreement he had made with me. We have since come together again as friends but it took a long time for a trust factor to be re-established. Owner Occupy First This is a great idea that should be explored more often. For their first property, many first time buyers should consider buying and living in a rental property as a primary residence. As discussed earlier, you can get owner occupied financing on buildings up to four units. It is possible to get up to 100% financing at very favorable owner occupied rates. On the other hand, if you don’t want to owner occupy the building and only want to buy a property as an investment you will need a larger down payment. The mortgage rates on investment properties will carry anywhere from .5 to 1.5% higher interest rates than the same financing for an owner occupant. The mortgage rates on investment properties will always exceed that for owner occupants. This strategy has worked well for many of my clients. Initially they each lived in a property and then subsequently moved out and used the property as their first rental. I have five friends whom I helped buy duplexes as their first home. Each of them was initially an owner occupant and then subsequently moved out years later as their lives changed. While they were owner occupants they lived for free or at a very reduced cost. This allowed them to finish various educational pursuits, take trips, and purchase various cars and boats. When they moved out, they retained these properties as rentals. Each of them doubled or tripled the value of their properties. Their return on investment was exponential. A key point to consider is that the underlying mortgage financing was already in place. This means their mortgages couldn’t be changed-even though the usage of the property


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“Reality Based” Real Estate Investing was now changed. The same thing applies for accessing a home equity line of credit. Put a line of credit in place while you are the owner occupant. A little bit of upfront planning will go a long way towards being able to build your wealth through real estate.

Creative Financing As we’ve talked about before, I was 21 years old when I first started selling real estate. I succeeded in a large part due to my understanding and application of creative financing. Today, creative financing to the extent that I was able execute it, is now a thing of the past. Assumable financing without qualifying is gone. Nothing down creative financing like I first tried may work today on a property that is not very nice or one that exists in a challenged environment. When I bought my buildings, you could buy in prime areas with creative financing. It bothers me when I see so called real estate experts talk about what used to work 20 years ago and represent it as if it can be done the same way today. Unfortunately, times have changed but their teachings have not. Today, creative financing requires you to play a sort of shell game. You must be able to move money from various credit lines and from property to property. Maximum application of creative financing today demands that you have great credit scores so that you can qualify for the mortgage products and programs. At all costs, preserve your credit score. Having great credit will allow you to rebuild and fight another day.


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Chapter 5

Holding Period Considerations For Maximum Benefit Have you ever watched the TV show “Flip This House”? It’s exciting isn’t it? The idea is to buy a property low or under valued, strategically add value, and then sell for a higher price for a maximum profit. If only it was that easy. I hate to burst anyone’s bubble, but in real life flips aren’t that easy to do profitably. Did you notice the word profitably? Many attempts at flipping end with the profitability component missing. I would guess that there are people you know who have tried a flip or two and didn’t make much profit. Let’s assume for a moment that you do a flip and make some money. One of the expenses that you will find overlooked is the tax due on your profits. If you’re determined to be a flipper or dealer in real estate which involves having a holding period of less than one year, your profits will be taxed at ordinary income tax rates. Taxes are the enemy to serious wealth accumulation. Instead, if you hold property over one year, you will pay taxes at the capital gains rate. The tax rate differential can be dramatic. The maximum federal capital gains rate is 15%. The maximum ordinary income tax rate can come close to 50%, depending on your tax bracket. Taxes alone can destroy your projects profitability. The resultant tax savings are one of the major reasons why I hold my properties for at least 12 months. I prefer to pay the lower capital gains rate. I would encourage you to do the same thing. If you do a rehab, rent it out for 12 months and then


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“Reality Based” Real Estate Investing sell it. If you are lucky, you may even be able to sell the flip home to your tenant. If you work with a mortgage broker that helps with credit restoration, you could enroll the tenant at the beginning of their lease in a credit repair program and have them credit worthy and ready to buy at the end of the lease. Another reason to hold for a year is that the building might be worth more in the future. This assumes a normal market where real estate is appreciating. In a normal market you will be rewarded with a higher sale price. We’ve already discussed holding property for more than one year to get a lesser tax liability and a correspondingly larger profit. What about a declining market? You should still plan to hold for a year. Rather than by design, you may end up renting your property out of necessity. In a declining market, you really need to buy the property right. In a declining market you will need to anticipate selling for less than you are projecting. A lower sale price needs to be factored into the plan. When I buy a property, regardless of an appreciating or depreciating market, I have a profit built in from the start. This means I buy at what I feel is a discounted price. Buying with a discount up front gives you an initial profit to work with from the start. This discount provides me a cushion or safety net. This is easier said than done. Because I am a real estate broker, I have access to the real time MLS daily. I can set up automated searches and alerts based on my parameters. This allows me to react quicker to opportunities. Even if I pay list price, I receive my sales commission. My commission provides me with a discount to the listing’s sale price. Having a clear understanding of the current market is yet another reason why you need to affiliate yourself with a real estate professional that will become a trusted adviser. If you attempt to search for homes on your own, such as randomly seeking out FSBO’s and in general show no allegiance to the real estate person helping you, then expect the same in return. On the other hand if you view your real estate investment successes as being mutually beneficial, you will be on the real estate person’s “A” list of favorite investors. The “A” list will be the first one he/she calls when an opportunity crosses his/her desk. One of the first things we talked about in the beginning of this book was to set goals for your real estate ownership. Part of your goal achievement involves projecting the holding period of your properties. You can make various assumptions as to cash flow, expenses and appreciation. Once you do this, you can begin to see where you think you can maximize profit. Calculating profitability can be done by creating a form that allows for the input of a subject property’s corresponding income and expenses. When you subtract the two, you will end up with either a profit or loss from the property. To determine the overall profit over your entire holding period, you will need to put in all the acquisition costs and disposition costs together with the tax benefits of depreciation and appreciation. The key to the sheet working is in imputing correct data. Do you think your property might ever become vacant? Many people forget to put in a plug figure for vacancy, assuming instead that the property will always be rented. I would recommend you put in at least a 10% vacancy factor. In some transitional areas it may be even greater.


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Another item often missed is the adjustment for a shift from homestead taxes to non homestead taxes. When you turn a property from an owner occupied property to a rental the taxes increase due to the non homestead classification. Thankfully, today you will find the differential between homestead and non homestead taxes is not as great as it was it the past. It still is a factor, so you will need to make an adjustment to your cash flow numbers. To get an accurate number, you will need to call the city assessor’s office and ask them to provide you with the non homestead tax. What is your time worth? You should input a cost associated with the building’s management even if you manage the property yourself. You should calculate a value of your time and effort for the management. If you weren’t managing your building, you could be doing something else with your time. Historically speaking, long term appreciation will help overcome some of your costs or losses. In general, the longer you hold a property, the greater the appreciation that occurs. Most people who flip property hold their building for a short time period. This is yet another reason why flipping can be so expensive-there is little time for much appreciation beyond the value added improvements that you make. You will have limited your appreciation potential to a much shorter period of time combined with the greatest tax liability on a profit. One argument you could make in favor of flipping is that it allows you to turn over your capital more often. You may have the ability to find a number of discounted opportunities on a very regular basis. In this case, you will want to keep your “Money in Motion”. For example, if you can do four deals a year by turning properties over rapidly, you might be able to make a higher profit net of taxes than if you had tied up your capital in one deal holding a specific property for 12-18 months. Events may occur which will require you to reconsider your holding period as markets are dynamic and are subject to change. I gave you an example of this when I explained why I sold my duplexes. Times changed and I needed to react accordingly. You need to be flexible enough to react to the market and hopefully be able to capitalize on developing trends. Real estate holding periods will vary by property, by your goals, and by geography. I have found that the most successful investors I’ve met tend to foster a buy and hold mentality. REMEMBER-real estate follows cycles. Buy at the bottom of the cycle and sell at the top of cycle. While it is impossible to catch the absolute tops and bottoms of cycles, the goal should be to get close. Although this may be hard to do both emotionally and in practice, this is what you need to strive for. Wealth generation generally takes time and isn’t created over night. Real estate tends to appreciate over a long time. If you live in a community like the Twin Cities, which is projected to increase in population by over one million new residents within the next 15 years, then appreciation is probable simply based on supply and demand. You will generally find appreciation to be greatest in areas with amenities, good accessibility, decent schools, and low crime.


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Let’s review in a little more depth my example of market trends and how they impact holding periods. I briefly explained some of this when I reviewed duplexes as type of property in chapter one. I sold two duplexes in 2002-03 that I acquired in 1990-91. This was an extreme valuation point in the real estate market cycle. Four key variables all converged at once. Three of four variables were in my favor and allowed buildings to be worth their highest valuation. In retrospect, I concluded correctly that it was a good time to sell. Let’s next examine each variable and see how it affects a building’s value. Variable #1-No supply and huge demand In 2002-03 all the stock market investors wanted to be in real estate. There was large demand for rental real estate and very little supply available. Many times investing was done with no regard to what a building would yield as an investment. Also, at this time you had many newly minted Realtors who had never owned rental property advising people who also had never owned rental property. Can you imagine a sillier scenario? This was a classic example of novices leading novices into the lion’s den. Next, compound this dangerous environment with the emotion of greed. Greed often accompanies a scarcity mentality. In fact, you may remember that people stood in line in some areas so they could purchase condominiums as investments. Their plan was to sell it before they even had to close on the property. I call this the “greater idiot” theory. You buy something based on no economic principals and then hope to find a greater idiot than you to whom you can sell your building. This worked for a while. Whenever you create an auction like atmosphere or feeding frenzy, you will get a situation where people pay too much. Variable #2-Interest rates were at a historic low Interest rates dipped to their lowest point in approximately July of 2003. You can afford to pay more for a building’s cash flow when the interest rates are low because the lower mortgage payment will allow you to finance a larger amount of mortgage debt. This means properties could be valued higher simply on the basis of available financing. Because interest rates were at 50 year historical lows, people should have recognized this rate could not be maintained. In their property analysis, they should have used rates that would more closely track historical averages. It would have been reasonable to do this since the most likely outcome would be interest rates reverting back to some historical average over time. If interest rates were to increase in the future, the natural outcome would be a smaller mortgage financed with the same payment. This means buildings would have to drop in value. This is exactly what happened.


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“Reality Based” Real Estate Investing Bear this history lesson in mind when you enter the market to buy rental property. A more realistic and safer approach would have investors using some historical average of interest rates in their valuation model. Don’t get caught up in the frenzy. Variable #3-Minnesota had a property tax surplus Can you believe we actually had a property tax roll back? In 2002-03 property taxes were lowered to some of the lowest levels Minnesota has experienced in recent years. Regarding investment properties, Minnesota finally reduced the disparate tax levy due to non-homestead tax classification. Yet, there still is a differential between homestead classification and non-homestead taxes as the discrepancy wasn’t completely eliminated from our tax code. Regarding this issue, I have yet to understand the justification behind this taxation inequity. Why should rental property be taxed at a higher mil rate when no more city services are utilized? Instead, society as a whole is benefiting from the greater social benefit of having more affordable housing choices. The mil rate is defined as the tax per dollar of assessed value of property. The tax rate is expressed in "mils", where one mil is one-tenth of a cent ($0.001). Today, the discrepancy is less dramatic but no less unfair. At one time rental property owners were paying almost 3 times the property tax amount due to the rental property tax classification. Today, instead of 3 times the amount, it is now about 1.25-1.5 times. In addition, the state created a special tax status for apartment buildings where the owner agrees to rent to certain lower income individuals. Some property owners decided to pursue that market. If/when the property should ever revert back to market rates with market tenants, the taxes will increase to what they would be without the special classification. Imagine if you were an unsophisticated investor who didn’t understand this. You would look at the current taxes and make a cash flow decision that might look better due to the special property tax classification. Since this variable could change, you should use a true market based tax in your analysis. Many investors did not do this and paid too much for their building’s cash flow. Also, up to this period in time, buildings were not assessed at full market value. It was very common to find a building’s tax assessed value to represent only about 80% of what it was really worth. Today things have changed. Today, buildings are often taxed at true market value or above market value. This in turn leads to higher taxes which will correspondingly reduce your cash flow. In the future, regarding the correct number to use in your property tax analysis, always base it on a building’s true market value and the taxes that would be attributed to that value.


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“Reality Based” Real Estate Investing Variable #4-Lack of qualified tenants The lack of credit worthy tenants in the marketplace was one of the major catalysts for me to sell my buildings. I used to run a rental ad in the newspaper from which I’d generate a list of 10 people waiting to rent my building. Nine of the ten were excellent prospective tenants. Over time, this changed. The tenant pool declined. It got to be where one person would show up to view the property and they were not quality tenant material. My buildings were located just three blocks from Lake Nokomis. The location was excellent and the buildings were sound proofed and updated. These were beautiful buildings in a high demand neighborhood. What was the problem? Where did all the great tenants go? They became the homeowners that fueled the housing boom. Before the subprime bust and foreclosure explosion, we had a booming real estate sales environment. Part of the reason we had such an expanding real estate market is because the mortgage industry created mortgage products that allowed almost anyone with any situation to become a homeowner. The reason there were so many great tenants in the past is that the lenders had tighter underwriting restrictions. In the old days you needed job stability and a down payment. Good tenants in the past could have afforded a house payment but couldn’t qualify for a mortgage due to the tighter lending requirements. In the first part of the century, lenders created new programs to help these great tenants obtain financing so they could become homeowners. As demand for loans and mortgage securities grew, acceptable underwriting guidelines were expanded to where it became ridiculous. Here are some examples of the lax standards to which I’m referring: getting a loan one day out of bankruptcy, one day after your foreclosure, no money down, no job, no credit, stated income-you decide what your income is going to be, No Doc (No documentation)-nothing stated on the application except name and social security number, No ratio-loans that don’t use income to qualify because there is no debt ratio calculated, 100% financing, and 125% financing. Can you begin to see why we have an epidemic of foreclosures today? In this loose lending environment, tenants were tenants because they truly wanted to be tenants or because their credit or job situation was simply atrocious. As I just mentioned, I was seeing the effects of the mortgage market programs in my potential tenant base. I still wanted to own rental real estate but I wanted to draw from a different tenant base. I sold the duplexes and bought new construction condominiums. I had to go back to my goals and revise them. I identified the potential tenant I wanted to rent to: a tenant that would be attracted to a new property instead of an older apartment or duplex, someone who was possibly more mature and wanted to live among primarily owner occupants and a correspondingly quiet environment, a tenant who had rental choices because of their credit, income and job status and someone who could afford to pay a decent market rent.


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“Reality Based” Real Estate Investing Where are we TODAY as a result of the easy mortgage money of YESTERDAY? While these loans I’ve just reviewed existed during the housing boom, most are not available today. Sadly, many people today could have become homeowners had these programs stayed in place. This is why we have approximately 34,000 homes for sale within the Twin Cities. The pendulum has swung too far from what was acceptable in the past to what isn’t acceptable today. One solution to the problem could have been to allow some of the discontinued mortgage programs to continue by imposing tighter underwriting guidelines tied to a higher credit score requirement. Many of these mortgage programs have been discontinued due to the inability of the mortgage companies that created them to be able to sell them to investors. They aren’t bad loans. They didn’t create the foreclosure problem that we are experiencing today. People chose not to make the payments for various reasons. Sometimes foreclosure is truly due to hardship such as illness or some tragic family or job event. Some borrowers didn’t make their mortgage payment because they didn’t have any equity. Even worse, other borrowers had negative equity due to a declining market. Negative equity makes it very easy to walk to away instead of struggle through the pain of waiting for the market to come back. Take note that we had very few foreclosures in a rapidly appreciating market. People were able to sell their way out of their problem. When a building is financed at 100% and then the market values decline, you can see how easy it is to become disenchanted with a property. Next, let’s look at ARMS (adjustable rate mortgages) and the blame game surrounding the defaulting ARMs in today’s mortgage environment. When an ARMs adjusts, borrowers have the option of paying the new payment or refinancing to a new payment. Refinancing is an option if the homeowner has good credit. If the homeowner had made their payments on time, they would have had good credit. Many of these ARM loans were 2/28 or 3/27 loans. This type of loan is a 30 year loan that has a fixed rate for either the first 2 of 30 years or the first 3 of 30 years. After the fixed rate period of time, the rate will become variable. The theory behind this type of loan is that you will act responsibly with your credit during the fixed two or three year period and then be able to refinance to A paper rates. After timely payments, when the ARM adjusts you will have good credit. Guess what happened? People didn’t change their habits. In my opinion, bad credit is often a lifestyle choice. These choices involve paying bills on time or buying a case of beer, cigarettes, a new car, cell phone, new car, etc. This isn’t to say that we all don’t experience life events beyond our control which can give us a temporary period of financial stress and blemished credit. But, too often, I see others wanting to blame someone other than the man in the mirror for their problems. Too often, I see people taking the easy way out and walk away from their obligations. Many people could work their way out of their financial problems by taking on a 2nd or 3rd job until they get back on track. If people really understood the ramifications of maintaining bad credit, they might be more responsible and live less for today and more for tomorrow. The lifetime higher cost of borrowing and the lesser quality of lifestyle from having to pay higher rates is staggering.


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“Reality Based” Real Estate Investing Regarding foreclosures today, please don’t blame the lenders, brokers, or investors. I want to assure you that nobody put a gun to any borrowers head and made them sign loan documents. Many in this country believe that entitlement to the American Dream with all of its spoils appears to be one of man’s unalienable rights. We all can and should have it all, right? Our media reinforces this daily. We are constantly being marketed to via TV, radio, magazine and on the internet. You DESERVE IT! IT IS YOUR RIGHT! Yet we as a nation have forgotten the lessons of our forefathers. We need to look no further than one generation of immigrants from the past to see what can be accomplished when we really work hard. America needs that work ethic back. We run the risk of becoming a fading nation whose greatness will be a memory in time. This has happened throughout history to many great nations and many great empires. Are we sowing the seeds of our own decline? Is it really going to be different this time? Ponder these questions as you go forward.


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Chapter 6

Tax Benefits Of Real Estate Ownership One of the best resources for tax information is the IRS. You can go to www.IRS.gov and research the following topics: depreciation schedules, schedule E, 1031 exchange, dealer in real estate, and capital gains. Because laws change and everyone has a different situation, I will just cover some of the highlights regarding real estate and taxation. The current laws around capital gain taxes allow you to sell an appreciated asset that has been held for more than one year and pay a maximum federal tax of 15%. Various states may impose additional taxation on your capital asset sale. The current maximum federal tax rate is the lowest capital gains tax we’ve had in years. The theory behind a lower capital gains tax is that it will induce sellers of highly appreciated assets to sell their assets and put those dollars back in motion within the economy through reinvestment. If large sums of equity sit locked up as free and clear equity/appreciation, the government isn’t able to generate growth or tax revenue off of this value. If taxes are low enough, people will unlock their equity by selling these highly appreciated assets and pay the corresponding taxes. When taxes are high, people don’t sell these highly appreciated assets. Thus, you can generate more taxes and more economic growth through lowering the capital gains taxes -not raising them.


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“Reality Based” Real Estate Investing Tax laws can be changed by political administrations. Some administrations believe in free will of the individual and less government while others believe the government knows what is best for you and that you need more government involvement in your life and decision making process. These same two parties are diametrically opposed in their ideas on taxation and capital gains in particular. Who prevails in the White House and Congress should have some bearing on when you will want to sell your property. One political party will likely try to raise the capital gains tax as a way of raising money and redistributing wealth. Each party has already indicated their intention. Go back and review your goals as they pertain to taxation under the victory of either administration. Don’t overlook the fact that you can offset other capital losses against other capital gains (it doesn’t have to be just real estate against real estate), so the timing of the sale of some other assets such as stocks may need to be incorporated within your tax loss/tax recognition strategy. Depreciation allows you to devalue a building based on the obsolescence of its economic life. Currently, our tax code requires that you use a straight line depreciation schedule. This means you take the value used for depreciation and divide it out over a set number of years. The resultant number is the amount you can show as a loss for depreciation on your taxes. If you are an active investor who does the majority of the management yourself, you may be able to deduct depreciation against your building’s income. Currently there is a phase out of allowable depreciation that declines based on your income. There is also a provision in the tax code as to whether or not you are considered an active investor, passive investor, or a dealer in real estate. These issues should be discussed with your accounting professional. You can review the IRS guidelines as it may apply to your situation or call the IRS at 1-800-829-1040. There is an under utilized provision regarding depreciation of rental property that allows for the acceleration of the useful life of appliances over a five year period of time. This means you can show a greater loss against your building because of the shorter life span of the appliances. The greater loss is reflected by the shorter depreciation period. For investment properties, the straight line depreciation schedule for residential real estate is 27.5 years and 39 years for commercial real estate. Land is never depreciable, so you need to back that value out of your purchase price to determine the actual value of the building. You need to know about something else. It’s called recapture. This part of the tax code requires that you pay back a portion of the depreciation that you’ve previously reported on your taxes. The good news is that the maximum recapture rate is 25%. See IRS code section 1250 for the rules. When you repay recapture, you are paying back in future value dollars what you were getting for a tax deduction today in present value dollars. If you were to effect a 1031 tax deferred exchange, you will defer the tax liability of the recapture and capital gains until you no longer want to own real estate or its equivalent. We will explore this more in the next chapter.


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“Reality Based” Real Estate Investing The Schedule E is a property’s profit and loss statement. This is one of your best tools in determining how a building REALLY works. You will want this when evaluating an investment property that is supposed to be generating an income. When I have made offers on apartment buildings, I’ve requested to review the seller’s schedule E. I have had seller’s refuse to give it to me. There is only one reason why they wouldn’t provide it. Care to guess? It may be because they are lying about the numbers. A seller may falsely tell you that a building generates a certain amount of net income. How do you really know? Are there side deals with the tenants regarding the rent or were rents just increased? Do the rents represent a sustainable rent level based on the current market conditions? Don’t buy a true investment style building, i.e. an apartment, without reviewing at least the past two year’s schedule E’s. Let me tell you about a cool strategy. This might work for you if you are not opposed to moving often in order to gain equity. In years past, there existed the age 55, $125,000 one time equity exclusion. This is now long gone. In its place is a better law that allows you to avoid taxation on up to $250,000 in equity profits if you are single and $500,000 in equity profits if you are married. This is a renewable resource. The requirement is that you live in your home for two years to get the full amount of tax free profits. The government is giving you an opportunity to build huge wealth. I have one client who is in the construction business as a framing contractor. He and his crew were able to finish the basement of his first home and build some equity. He sold his home and took the finished basement equity and purchased a lot in Chanhassen. On that lot, he built an expensive home. A lot of the work was completed by doing much of the work himself. He built approximately $80,000 of sweat equity by using his and his contractor’s connections. Two years later, he sold this home and moved on to yet a bigger home. After living in that particular home for two years he moved again. For the moment, he is happy and content in his most recently built home. He and his wife have amassed almost $500,000 of equity over a very short time period by taking advantage of this two year tax free equity accumulation rule. How could you take advantage of this rule today? Most of us aren’t contractors and we don’t have a network of tradesmen. Still, you might be able to duplicate this experience to a lesser degree. Consider buying into a new subdivision. I’ve found that large national tract builders control most of the parcels of land that can be developed into 100+ homes. Initially, when a builder opens a development, he/she will do so in phases. Just like with the Emerald Gardens condominium, I’ve seen builders offer special incentives to those who want to be the pioneers in the new community. Sometimes the incentives are in no cost upgrades and sometimes it is in the form of a lower entry price. Depending on the real estate market, it may be both! Once a development starts to take off, the cost of each new subdivision increases and the incentives disappear. If you buy at the beginning and sell at the end of the development, you will generally have a nice equity position. Imagine if you did this every two years. I realize moving isn’t easy. For those of you who are willing to take a bit of a chance and try this strategy you may find yourself with a large amount of equity after just a short period of time. If you don’t have children and schools to worry about, this might be something to ponder.


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“Reality Based” Real Estate Investing Remember, we just talked about the two year exclusion of equity from taxation. It is precisely for this reason that you probably don’t want to rent out your primary residence. This is especially true if you have a large equity position. If you rent the home and later sell your rental, you will have converted tax free equity into taxable equity. You’d be better off buying your neighbor’s home and establishing a current market priced tax basis instead of renting out your current home. There is another loop hole that may eventually close that may be of interest to you. If you have a rental property that has a huge amount of equity due to a very low tax basis, you may want to consider moving into it as a primary residence and live in it for two years. If you do this, you will change the status to a homestead property. You will be able to sell it and avoid paying tax on the gain. You will be able to sell the property and exclude the $250,000 in gain if single and $500,000 in gain if married. Here is yet another idea on how you can beat the tax man. Simply die with appreciated assets in your estate such as low basis real estate and low basis stock. Upon your death, your asset will get a step up to market value. Depending on the value of your assets, you may be able to avoid paying estate taxes if your assets don’t exceed the estate tax exclusion at that time. Part of your overall master plan in owning real estate involves the correct timing of its disposition. This will involve trying to figure out how to maximize the amount left to your heirs by paying the minimal amount of taxes required.


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Chapter 7

1031 Exchange-The Key To Massive Wealth Accumulation Did you know that a little known US tax code technique can be used to maximize wealth creation? In this chapter I will share one technique that could yield you thousands if not millions of extra dollars of equity over your lifetime of real estate investing. Let me give you a brief overview of exactly what an exchange is and how easily it can be accomplished. When someone says 1031 exchange, they are referring to the IRS tax code 1031. This code refers to like-kind exchanges. A like-kind exchange occurs if you are exchanging business or investment property of like-kind. Under the code, investment property must be exchanged for an investment property but it doesn’t have to be the same kind of investment property in order to qualify. The replacement property must be of like kind. Here are just a few examples of properties that would qualify as like kind exchange properties: an investment single family house could be exchanged with another single family house, a duplex, an apartment, a piece of land, office building, warehouse, retail property, a percentage interest in a TIC, or even a triple net lease. The term TIC is the acronym for Tenant In Common and is a way for individuals to collectively invest in a commercial property or commercial properties. The investment required to invest in a TIC is generally higher than most other investments. Often, the cost of purchasing a TIC interest can be upwards of $250,000. Ownership interests and agreements are often structured to resemble that of a partnership.


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“Reality Based” Real Estate Investing A triple net lease or TIC might be your last exchange property and final exit strategy when you have accumulated a large amount of equity and are done dealing with tenants. A triple net lease allows you to receive a “pure” rent. The tenant is responsible for the taxes, insurance and maintenance-sometimes known as CAM. As you can see, the properties need not be the same to qualify as “like kind”-but they do need to be of the same nature or character, even if they are of different grade or quality. I have had clients who moved money from a triplex in California to land and property in Minnesota via a 1031 exchange. There are no geographic boundaries except for the fact that the properties must be in the USA or US Virgin Islands. Some states may have special rules on exchanges regarding their state only but most do not. A TIC is a tenant in common ownership interest in a commercial building. As an owner, you generally will receive a pass through of the income generated from the building’s rents. You will want to look at exchanging property if you plan to stay in the investment property game. It is the perfect way to dispose of one property or properties and continue to acquire additional property or properties. If you don’t want to own real estate, then you would just sell, pay the taxes on the profit, and then invest your proceeds into something else. 1031 exchanging is very powerful because capital gains and depreciation recapture taxes are deferred. While your tax basis remains what it was initially when you acquired your first property, you are able to compound and grow the dollars you would have lost to taxes. Think about how much extra money you would have if you didn’t have to pay taxes when you sold a property. Think about this over a few properties or your entire portfolio. The extra amount of money you would be able to accumulate over time would be huge. This will allow you to purchase more properties at higher prices. In some ways, you could say that you’ve been given a tax deferred loan from the government that is only due and payable when you exit the real estate business completely! You might be asking, “Why wouldn’t everybody do this?” Sadly, the answer goes back to what I’ve previously mentioned-it comes back to your advisors. Ultimately, you are responsible for initiating your own exchange and acquiring the appropriate knowledge. At the same time, if you are working with competent real estate and tax professionals, this should have been a discussion that was initiated by your advisor before your investment property went up for sale. 1031 exchanging and the tax laws pertaining to exchanging apply across the USA. Because of more rapid appreciation, the East and West coasts were some of the first areas in the country to become proficient in exchanging. The Midwest adopted these strategies a bit more slowly. I was involved in a real estate exchange club back when I began my real estate career in 1986. We used to meet at a hotel for breakfast. Various real estate agents and brokers would make a presentation of properties that were for sale or exchange. These meetings were a lot of fun. There were some real characters in this organization. Sometimes people need to add more cash to make an exchange work. This is called boot. Boot can be cash or an equivalent. Some of the boot presented at the meetings consisted of artwork, gun collections, and cars. Many of the people were trying to do a simultaneous exchange. Just as it sounds, a simultaneous exchange occurs


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“Reality Based” Real Estate Investing simultaneously when two properties are exchanged at one time. Simultaneous exchanges are harder to coordinate. There are several different kinds of real estate exchanges. Here are the most common types that you will encounter: simultaneous exchanges, deferred or Starker exchanges, reverse exchanges, and new construction/improvement exchanges. I will be addressing the most common type of exchange today-the deferred or Starker exchange. You should also be aware that there are prohibitions against exchanging a vacation home and doing exchanges with related parties. These are outside the scope of this book and I would refer you to the IRS for guidance. The mechanics of a Starker or deferred exchange are fairly simple and straight forward. 1) You must purchase an aggregate amount of real estate that is greater or equal in value to what you’ve sold. All your equity must be reinvested in these new properties. If you don’t reinvest it all, you will have to pay tax on the amount you didn’t reinvest. What if you would like to get some cash out of the property on the first sale and not have to pay any tax? Here is an idea on how you can get some cash. Initially you would invest all the proceeds in the replacement property (ies). Later, in a subsequent transaction, you would refinance the replacement property (ies) and pull out your equity. Borrowed funds are not taxable, so this is a perfect two stage approach to minimizing your tax liability while maximizing the potential cash out you can receive. 2) You cannot touch the proceeds nor have any “constructive receipt” of the funds. You need to hire a qualified intermediary or accommodator to avoid having constructive receipt. Many times this entity is the title company where you are closing your sale. Sometimes it may be a separate third party such as an attorney or a company that only exists to act as an intermediary. I have used all three variations of intermediaries for my clients: title companies, third party exchange companies, and attorneys. In each case, the intermediary holds all the proceeds. This means you walk out of the closing without a check. The typical fee to act as the intermediary might be $500-$1000. If you employ some of the other types of exchanges such as a reverse exchange or construction exchange, the cost will be higher. 3) You must take a few initial pre-sale steps along with a few post sale requirements. Pre-Closing, you will want to have an exchange agreement with the intermediary. This will identify the cost and responsibilities and show intent to do an exchange. In your purchase agreement for the sale of your property, you should include some language such as “all parties are aware that this property is part of a 1031 real estate exchange and all parties agree to cooperate and facilitate this transaction.” At the closing table, you sign the papers and leave without any money as the facilitator has the funds. 4) Next you must identify and close on one or all of the replacement property or properties. You have 45 days from your closing date to identify up to three replacement properties. You also have 180 days from your closing date to close on one or all three replacement properties. These timelines are set in stone.


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Exchanging will not affect your ability to obtain a mortgage. The lender just needs to see the original paperwork pertaining to your first sale and the escrow intermediary agreement that you obtained at your initial closing. You will make the mortgage application in your name and you must qualify for the new mortgage. The cash down payment comes from the exchange intermediary account and is released at the closing of the replacement property (ies). My mortgage company, Venture Development, has helped many investors obtain a mortgage as part of the exchange process. There are times when an exchange may not be the best choice. One particular situation comes to mind. You might prefer to have a sale instead of an exchange if you have a large capital loss that would otherwise sit suspended. The large capital loss might be so large that there is no conceivable way you would use it up in your lifetime. This would be the perfect time to sell a property and offset your large capital gain with the large capital loss. Assuming the gain and loss were of equal amounts, you would not have to pay any capital gains tax on this transaction. You still would recognize the recapture of the depreciation you’ve previously taken. This may work out better for you than deferring the gain and having a large suspended capital loss. As with all tax strategies, each situation is unique. You will need to consult with your appropriate advisors to see what is best for you. Two qualified intermediaries that provide a lot of useful information about 1031 exchanging are Starker Services http://www.starker.com and Timcor Exchange Corporation at http://www.timcor.com. Under current tax law, there is the possibility of converting an exchanged property into a personal residence. I have a client that has done this successfully. He initially exchanged a lake lot for a townhouse and later moved into the townhouse as his personal residence. The key point that made this transaction work was that he ultimately moved into the rental property and converted it to his primary residence. He lived in the converted rental property for two years. By doing this, he was able to convert all of the accumulated tax deferred gain that had originally come from the lake lot into a primary residence that was now subject to the two year hold, $250,000/$500,000 primary homestead exclusion. Tax laws are always changing. For further clarification on holding periods for converted rental property into homestead property, I will refer you to legislation signed on October 22nd, 2004 regarding this in IRC 121. This legislation refers to a five year holding period in order to qualify. Since this legislation, the IRS has clarified it further, with a new ruling for sales after January 27, 2005 that lets you do an exchange on any excess over the exclusionary amount of the $250,000/$500,000. This could be huge for the right person in the right situation. This means that you might want to consider purchasing rental property today that will ultimately serve as your primary residence in the future. Plan ahead and consider doing some exchanging into property that you ultimately might like to call home. As you might expect, IRS rules are always subject to change. Always consult your tax advisor and IRS for the latest information.


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Chapter 8

Lease Considerations-Clauses & Concerns Does thinking about interfacing with tenants make your hair stand on it’s end? Is this one part of owning rental property of which you are most fearful? Don’t worry; I will try to assuage your fears. Yet, this is another one of those areas that can make or break your rental property career. If you do this part wrong, you will not enjoy being a landlord. Other parts of owning rental property sometimes take care of themselves. For example, it is possible that if you over pay for a property, in time you may overcome this through appreciation. If you pick the wrong financing, you can always refinance. But, if you pick buildings that only attract bad tenants or if you are not selective about finding appropriate tenants, you will undoubtedly sell your building and put the entire idea of being a landlord behind you. Dealing with bad tenants can be very discouraging. To borrow a cliché from the anti drug commercials of the 80’s-“Just say no” to bad tenants and the properties that might attract them. In my opinion, the State of Minnesota has created laws that are biased in favor of tenants. If you would like a free copy of the booklet “Landlord And Tenants: Rights and Responsibilities” which is provided by the Minnesota Attorney General’s office, go to http://www.ag.state.mn.us and download a free copy. This booklet covers the laws and provides the statutes that are applicable to owning and managing rental properties. The state provides other useful booklets, too. Order or download as many as you wish. Now that we know that the laws are slanted in favor of the tenant, we must select our tenants with extra care so we don’t run afoul of the laws. It doesn’t mean we can’t win at


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“Reality Based” Real Estate Investing the landlord game. We must be careful and become very knowledgeable about of the laws. With this in mind, I’ve observed a few landlord mistakes that will almost always cause you problems. This is one place you CAN learn from others. First, always require a criminal and credit background check as part of every application. The saying goes, “You can’t judge a book by its cover” and this certainly is true with tenants. Always, always complete the screening process regardless of what your first impression might tell you. Most professionally managed rental properties have an application fee and the fee is generally equal to the charge from the rental screening agency. Prospective tenants are used to paying this fee and you should charge it. Usually, the cost to do the criminal credit search is around $25 and is non refundable. I use a company called Rental Research. You can find them online at http://www.rentalresearch.com. There are other companies that provide rental screening. The point is, have a screening service in place. Screen the tenants according to your accepted criteria and stick to it. Have you ever seen the movie Pacific Heights with Michael Keaton? This should be required viewing for any prospective landlord. When you are done reading this chapter go out and rent the movie. In the movie, Michael Keaton is a very very bad tenant who preys upon the desperation of a new landlord who is out of money due to renovation cost overruns. I don’t want to say any more as I want you to see the movie. Second, consider establishing two rules for your properties regarding pets and smokers. Keep these rules as sacred and use them to define your tenant criteria. Promise yourself you will never deviate from these rules once they are in place. I do not rent to smokers or anyone with a pet. I have in the past. I’ve learned my lesson. Learn through my mistakes. Smokers and pet owners are not a protected class-hence you are not discriminating. You can have no smoking as your building or rental criteria. You might want to visit http://www.MNsmokefreehousing.org for more information. Once you set the criteria, advertise it in your rental ad and do not deviate. You don’t want to be accused of changing criteria for one group of renters and not the other, that is, discrimination. Why would you want to exclude these groups? Let’s look at each group. Starting with smokers, there will be more wear and tear on your property. You will have to repaint sooner and you will have to replace carpet sooner. At the same time, how many non smokers will rent a place that smells like smoke. The answer is none or almost no one. This means you may have to spend the money for the repair/replacement sooner than you had hoped. Imagine if a tenant moved out after one year. It would cost you more for carpet and paint than the rent you would have generated over the year time period. The next group is pets. In the past, I have allowed tenants with pets. I speak to this with first hand experience. That being said let me add that I love pets and have had them in my personal residence. I have nothing against them. I just don’t want them in my rental property. From my landlording experience, all cats spray. I’ve been told otherwise, but I don’t believe it anymore. My experience with cats has been poor. One town home I was managing for my family had very expensive grass cloth wallpaper. The wall paper became my tenant’s cat preferred scratch pad. That particular tenant’s cat also permanently stained brand new Berber carpet with urine and fur ball stains. The total


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“Reality Based” Real Estate Investing damage came to about $3000. I could go on with pet stories but I think I’ve made my point. Suffice to say that pets cause extra wear and tear on a property. Even if you disagree with what I’ve just said, I have yet another reason for you to consider. If you have a new prospective tenant that has allergies or is offended by pet smells he/she will certainly select a different property. If you still want to open your property to either smokers or pets, you might want to increase the rent or require a larger damage deposit. A contrarian argument could be made that these two groups of tenants face limited options. Therefore, if you are willing to accept them, you will have a niche tenant base in which to market. These tenants may stay longer since they have fewer options for housing. Even with this positive slant, it isn’t a niche I wish to pursue. A point we’ve discussed previously is that you need to think about the type of tenant you wish to interface with when you buy your property. For example, if you are purchasing a condo in a high rise you will have a different tenant than if you owned a property in a very transitional neighborhood. A more transitional area may have a tenant base more predisposed to seeking a rental relationship under Section 8 instead of at open market rates without any government subsidy. Section 8 is a program where the rent is subsidized or paid completely by the government. With my properties, I want to deal with as few problems as possible and have the most number of prospective tenants. For me, this means avoiding transitional areas and avoiding Section 8. This takes us back to location-location-location. We have had this discussion earlier in the book so I won’t repeat myself. I don’t want to have to enforce my leases in family court for non payment of rent. I don’t want to negotiate with tenants for rent. I don’t want to file an unlawful detainer (UD) action against someone for non payment of rent. I have purchased properties where I think I will have the best chance of finding many credit worthy tenants who have the ability to pay full market rent without a subsidy. When you have a property in a desirable area, you will be able to enforce a more stringent tenant criterion such as prohibiting smoking and prohibition against pets. This is because you will have a greater number of prospective tenants. The better properties will always attract a larger tenant base from which to choose a tenant. On the other hand, in certain areas and with certain properties you may find that setting up restrictive tenant criteria will eliminate most of your prospective tenants. This is often the case with properties that are being marketed with heavy cash flow. These properties are generally located in more transitional areas. Don’t buy perceived cash flow unless you are prepared to earn it through a lot of hard work to collect the rent. How much of your time and effort are you willing to devote to this? If you don’t want to do it, then you will need to hire a property manager. Once you have found a prospective tenant, he/she will need to sign a lease. Properties such as condominiums and townhouses, which are generally subject to an association, may require you to have a tenant sign a one year lease. They may also require you to do a background check and submit both the lease and the background check for their review and approval. Some associations require that the tenant obtain a rental insurance policy. Once the tenant has his/her policy in place, you will need to provide the association with a copy. Make sure you read your associations rules and regulations. You must comply


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“Reality Based” Real Estate Investing with the rules. You also should state that this lease is subject to the rules, regulations, and bylaws of an association, which shall supersede this lease both now and in the future. This will protect you in the event that the rules are ever changed and your lease has language that is in conflict with the new rules. Also, you must provide a copy of the rules, regulations, and bylaws to your tenant. Have the tenant sign off that they have been provided. You can’t expect tenants to conform to the rules if they don’t know what they are. Another question that comes up often regards the type of lease one should use and where you can get one. Personally, I prefer to use the lease and landlord kit that is available for purchase from the Minnesota Multi Housing Association (MMHA). There isn’t one single approved lease for use within our state. At the same time, there are things you can’t have in a lease. I don’t want to use an illegal lease. I want a lease that conforms to the state laws and has the best interests of the landlords in mind. I feel this is best accomplished by using the Minnesota Multi Housing Association lease. MMHA represents all landlords- small landlords and large multi unit owners who have thousands of units. Their leases stand up in court. It is always a good idea to have any lease you decide to use reviewed by your attorney in advance of using it. The last thing you want is to lose a lawsuit or eviction because you used an illegal or unenforceable lease. MMHA also provides addendums for pets, non smoking, and lead based paint, etc. They sell a great starter landlord kit for $20 for members and $40 for non members. You can go to their website at http://www.mmha.com and order a kit for yourself. While you are at their website please consider becoming a member. The membership cost for small landlords in under $100 annually. Another excellent resource is the http://www.completelandord.com. They have a free report entitled “Rental Property Management Secrets For Landlords” which you can get from their site. They provide other resources, too.


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“Reality Based” Real Estate Investing Here are some additional tips on leasing: Tip #1 Name all of the occupants in the property Always list the names of all of the tenants and occupants on the lease. Follow their names with a comma and the words “only” like John Doe, only. This will clear up any confusion if you need to have the police involved at a later date. There should be little to no confusion as to the legal occupants of the property and who are guests or trespassing. Tip #2 Create an addendum to the lease Always have an addendum to the lease specifying such things as painting. Additionally, consider these items: indicate whether painting is allowed or not, who can change the locks during the tenancy, renter’s insurance requirements, your ability to gain access to the property for sale or viewing with a certain amount of notice, define the responsibility for guests and their actions, establish a penalty for late payments or returned checks if you want something stricter than what is in the lease, and define the responsibility for your costs of attorney fees should you have to initiate legal proceedings against the tenant. Tip #3 Require a 60 day notice Always consider having a 60 day notice period in your lease. This means the tenant must give the owner 60 days notice before they can leave and the landlord must do the same if they want the tenant to leave. This is important because it gives you an extra 30 days to figure out if you are going to market and sell the building or to find a new tenant. If you don’t write this into your lease, you will have the standard 30 day notice apply as the default in Minnesota. In my opinion, you will find that the 30 day period is too short. Tip #4 Damage Deposits Don’t forget to return the tenant’s damage deposit within the required time period and with the required amount of interest. Currently, Minnesota law requires you to return the damage deposit to the tenant with simple 1% interest on the initial damage deposit. You must return the required amount within three weeks of the tenant vacating. If you are not going to return the tenant’s full damage deposit with interest, you will need to indicate why in a letter within this three week period. Failure to do this will cost you treble damages in court. Even if the tenant trashes the building and is entitled to nothing, you still must send the letter. Many newbie landlords have had insult added to injury when a tenant sued and won their case against the landlord because they didn’t send a letter. When I send my letter with anything less than the full damage deposit with accrued interest, I make sure it is sent certified mail with a signature return receipt required. If the tenant knows they won’t be getting any money back, they will usually disregard picking up the letter. In that case, when the letter is returned, put it in your file and save it in case you need to prove in court that it was sent.


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“Reality Based” Real Estate Investing Lastly, you should also know that when you buy or sell a building, the existing lease and its terms along with the occupants stay with the property. This means that you will inherit the current tenant(s) when you buy a property. One of the duplexes I purchased had a tenant named Keith. Keith had a history of non payment of rent. In fact, he was one of the main reasons the seller was selling the building. The owners were sick of trying to get Keith to pay. When I bought the building Keith was behind on rent. He was also behind on his utilities. He now became my problem. Our local gas company had turned off his gas due to non payment. He was heating his side of the building with his electric stove and any heat that crossed from the common wall of the duplex. I was very afraid of my pipes freezing. After negotiations, Keith agreed to leave at the end of the month in return for being able to just leave and not pay his back rent. In the interim, I called the gas company and instructed them to put the gas bill in my name. I wanted the heat back on to protect the pipes. The gas company refused to do this until I paid some of Keith’s gas bill, since he was still in the building until the end of the month. Needless to say, not receiving rent and having to pay someone else’s gas bill didn’t make me happy. At the same time, it was a business decision. Would it have been better to have spent money on an unlawful detainer and end up with the same result? Would it have been better to end up with frozen pipes and the damage or to pay part of the gas bill and protect my investment? I think the answers are clear. This forest for the trees thinking is what you need to do as a landlord. In business and life, you have to pick your battles with the end game in mind.


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Chapter 9

Title-How you want to own your real estate I think most people want to own property in their own name. You will find that it makes life much easier. It also allows owners to be able to utilize the building’s depreciation on their tax return. Some people own property in a corporation or corporate entity. Depending on the corporate entity that is used, you might not be able to use the building’s depreciation. In addition, you may bring on some unwelcome tax consequences when you sell the building for a profit. Consult your advisors before you title buildings in anything but your name. Other real estate guru’s may suggest you own buildings in an LLC or corporate entity. The advantage of a corporate shell is that you are able to avoid personal liability. This will be the case as long as you actually maintain the corporate shell. Many people create these types of entities but then don’t conduct business as that entity. For example, I’ve seen some people comingle personal and corporate assets and bills and act more like a sole proprietorship. If you do this, you may lose the protection of a corporate veil. Creating and maintaining a corporate shell will also involve both initial and ongoing costs. This can be an expensive proposition for a landlord that owns only a few buildings. Another problem of owning property in a corporate entity is that you will be unable to qualify for the majority of residential financing mortgage products. Corporate entities


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“Reality Based” Real Estate Investing generally are limited to commercial financing. Since I am recommending you primarily purchase residential type property, you need residential financing. Remember, commercial financing generally is less favorable. Think about creating corporate entities for apartment buildings and commercial properties. If you are involved with these types of properties, you are probably running a rental business as your primary business. In that case, a corporate entity might be appropriate. As just discussed, how you title a building will affect how you are able to finance the building. If you are married or have a partner, you might want to consider taking out the financing in just one of your names assuming you can qualify for financing with just one income. You can still be in title together. The reason to consider this is that it leaves the other spouse/partner unencumbered financially from the mortgage debt. This allows the unencumbered party to later obtain additional financing in their name. This can be valuable once you’ve maximized the financing in your name. Another reason people do this may be when one spouse/partner has lesser credit. Most loan programs are underwritten off of the middle credit score of the borrower with the lower credit score. If you don’t need the income of the other party to qualify, adding them can hurt your ability to get the best financing available if they have a lower credit score. This can impact loan to value, program, and interest rates that you would otherwise be able to obtain with your credit alone. If possible, use one person and always put your strongest borrower on the application. If you are concerned about asset protection, it might be advisable to split the ownership of your properties. You might find that your overall estate is protected better and you might be better able to utilize the estate tax exclusion. Estate and asset protection strategies should be coordinated with an attorney and financial advisor who work in that field. You may have been advised to buy a property in your name and later transfer it to a corporate entity. This could create an acceleration of your mortgage under the “due on sale” clause that is part of your mortgage terms and conditions. You may think that the lender won’t find out. You may have also been told that the transfer won’t evoke the due on sale clause. These statements may or may not be true. At the same time, are you prepared to pay off the mortgage if the lender demands repayment? Most people are not. Don’t play games and hope you won’t get caught. Play it safe and play by the rules. If you want to pursue some form of transfer, why not get a letter from the lender either granting permission for the transfer or providing clarification as to what is acceptable.


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Chapter 10

Insurance-Neglect This Area At Your Own Peril Let’s face it, in today’s world you run a good chance of being sued. You should plan on this occurring at some point in your lifetime. The best defense is a great offense and to follow the rules from the beginning. Ignorance of the law is not a defense. With that in mind, you might want to consider a few forms of insurance and various riders that could help limit your exposure. The first type of insurance to consider is an umbrella policy for liability. Generally, you purchase these policies from your property casualty agent-the person who writes your homeowners and auto policy. Umbrella policies extend the liability limits on your home, your auto, boat, rentals, land, and life. If someone sues you, the liability limits on your base policy may not be enough to cover the lawsuit. Insurance companies do not need to defend you in a lawsuit. They may determine it is cheaper to pay the limit of liability on the policy instead of actively mounting a defense on your behalf. It will be a business decision on the part of the insurance company. Do you know the cost of an additional one million dollars of liability coverage costs? It’s cheaper than you’d imagine-around $250 annually. You can get larger amounts such as two million dollars or five million dollars. Insurance in general is cheaper by the dozen. This means umbrella policies aren’t priced in direct proportion to the amount of coverage you obtain. I personally know of someone who was involved in an accidental automobile


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“Reality Based” Real Estate Investing death. That person had a one million dollar liability policy. To make a long story short, the person was sued by the family for a wrongful death. They wanted to get him personally for a lot of money and even wanted to pursue him criminally. In the end, the insurance company settled with the family for one million dollars which ended the case and allowed him to go on with his life. He got to keep his assets and did not go to jail. Imagine the legal bill and financial liability he would have had if he didn’t have proper coverage. This person became an advocate of umbrella policies as it literally saved his life. If you have assets or intend to have assets in the future you should really look into purchasing an umbrella policy. There usually is a limit on how many rentals can be covered by the policy. It will vary from company to company. A typical number is four. If you own more rental units than that, you may want to consider a separate commercial liability policy for your business pursuits. Contact your insurance agent to review all your options. Another insurance issue involves obtaining the right policy for each of your rental properties. There is a basic fire dwelling policy that covers the standard perils vs. a business owner’s type of policy which has better limits of liability and a few more bells and whistles. Some specialized policies will cover lost rents, vandalism, and higher limits of liability. Some landlords will wrongly assume that all policies are created equal when they are not. Shop for your rental property insurance as it will vary dramatically from insurer to insurer. Insurance companies will vary on what their policies provide in terms of definitions. Price is not the determinant of quality. The most expensive policy may not be the best. You may find that the cheaper policy offers better clauses. Until you compare the clauses and see what is actually covered, you just won’t know. Bottom line is that you want the best coverage that is available in the marketplace. I had an interesting situation with my BOP, Business Owner’s Policy. One of my tenants vandalized the property when she moved out. When I went to make a claim for the vandalism, the adjuster told me that he wasn’t sure that all the damages occurred at one time. If they occurred separately, they would individually cost less than my deductible. I was being set up to accept less than the four thousand dollars worth of damages. Ultimately, we settled on about $2000. While I believe this was wrong, it was better than nothing. In another situation, I had a tenant who damaged my windows by running a humidifier 24/7 in the middle of the winter. Can you guess what happened next? All of the moisture in the air from the humidifier condensed on the glass and dripped down onto the window frame. The water sat there for months and ended up removing the protective varnish finish on the wood. It started to rot the actual wood window frame. When I called to make a claim, the adjuster came out and took lots of pictures. After they had completely documented the claim, they pulled out the fine print of my policy and told me that I was not covered for this type of water damage. I believe the adjuster said something like this “According to line 3, paragraph 2, in the event of blah blah blah…YOUR CLAIM ISN’T COVERED”. Thank you very little. Needless to say,


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“Reality Based” Real Estate Investing these two examples show that insurance companies don’t give up their money very easily. That being said, you need to get the best policy available in the market. You may end up selecting an agent and company that is different from the company that insures your existing home and auto. Shop around for a rental property policy that is actually landlord friendly. Lastly, there is something called a CLUE Report. This report gives you a history of claims that have been made against the building. CLUE stands for Comprehensive Loss Underwriting Exchange. It is a national insurance industry database with more than 40 million personal property claims. The report generated from this agency is known as the CLUE report. If the property you are interested in has had lots of claims, you may find it almost uninsurable at conventional insurance rates. You may not find this out until after you’ve bought the building. This is why you want to request this report at the time you make your offer on the building. You want the report while you are still in your due diligence period. You will need the owner of the property to order the report and provide you with a copy of the CLUE report. Like the schedule E that we talked about earlier, if you have nothing to hide or nothing unusual to explain, then you should have no problem providing the report. A building that has had a lot of claims may be harder to insure. You still may end up buying the building, but you will have to factor a greater cost of insurance into your pro-forma. In addition, the report may bring to your attention some issues that you need to investigate.


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Chapter 11

Putting It All Together-The Next Steps TO RECAP Becoming a landlord can be a very profitable venture. With the right mindset and realistic expectations you will enjoy the experience. Many people can be a successful landlord if they want to put forth the required effort. It isn’t rocket science, but doing it successfully requires a commitment to gain a certain amount of knowledge and doing business the right way. Success with any endeavor, real estate included, will involve work on your part. Initially, I suggest you keep your purchases confined to single family homes, condos, townhouses, and duplexes as all of these properties can later be sold to both investors and owner occupants. Owner occupants buy property based on their needs and NOT on cash flow or lack thereof. Emotions will be a bigger part of an owner occupant purchase. A


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“Reality Based” Real Estate Investing property that can be sold to an owner occupant, like a single unit property, will offer you the best exit strategy. For newbie investors, I’d recommend you start here. In Chapter 1, we covered the majority of other real estate investment ideas that you can explore once you acquire more experience. Once you’ve made your decision about the type of property you want to acquire, you must decide on the location of where to own your property. I recommend staying close to home. There is a direct correlation with the desirability of an area and the corresponding sales price. Long term I feel you are better off in better areas, even if you are sacrificing cash flow and value for your dollar. Next we move on to financing. The key to maximizing profits parallels with how you pay for your building. You should match the property with the right financing. This requires taking into consideration all of the available mortgage program options and coordinating these with your projected holding period. Holding periods and tax considerations go hand in hand. Choices in these areas impact your building’s financing. You can see how various decisions become inter dependent. This takes us back to why you need a master plan or blueprint. When decisions aren’t coordinated and complementary they become out of sync and you get an incongruous outcome. Your projected disposition of the property should be contemplated at the time you purchase your property. If you are going to be in the real life game of Monopoly, you will want to utilize 1031 exchanges wherever possible. Two areas that tend to be neglected involve the titling of your properties and the type of insurance for your buildings. These considerations may seem mundane but are critical to protecting your wealth. Take these areas lightly at your peril. Now the fun part begins as you start to interface with tenants. Most everyone starts as a tenant sometime in their life. Try to remember what it was like working with your landlord when you were a renter. If you’ve never rented, then treat people as you’d like to be treated. The golden rule applies regardless of the endeavors you pursue in life. I am a very responsive landlord and try to make my tenants living arrangements as nice as possible. In return, I gain their respect. My tenants maintain my property in a responsible manner. Remember, tenants are helping to build your wealth, treat them as a partner and not with disdain.


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“Reality Based” Real Estate Investing CLOSING THOUGHTS AND MY PROPOSITION TO YOU: PLEASE TAKE ACTION UTILIZING YOUR NEW FOUND KNOWLEDGE!!! Thank you for taking the time to read this book in its entirety. I hope you’ve enjoyed reading it as much as I did writing it. My goal in writing this book has been accomplished if you’ve been entertained and educated at the same time. Please feel free to pass along this book to anyone who you think might benefit from it. Owning real estate is a great way to build wealth. I commend you for exploring this fascinating subject. If you have read the entire book up to this point I know you are a doer and not a dreamer. If you really want to be a successful real estate investor, I know you can do it. I believe in you. If you are serious about becoming a real estate investor and are looking for some assistance, I would like to help YOU. If you want an expert on your team, I am available as your real estate agent and/or mortgage broker. Remember to begin the mortgage prequalification process before you begin your property search. We utilize special programs such as the Credit Analyzer to help you improve your credit scores. Better credit scores translate into more product and program choices. Counseling/coaching you on specific areas that lead to credit score improvement are just some of Venture Development’s strong points. Did your last mortgage person offer to do this or did they just plug you into a program? I will give you a copy of your credit report during your free initial consultation. In nearly all circumstance, when you buy real estate you do not pay the real estate agent directly. Realtors/real estate agents are paid a commission which comes from the seller. Generally speaking, this means you don’t pay any money to work with a Realtor who helps you find a property. Remember, it doesn’t cost any more to work with the best. My value proposition for you is that you will be learning from my extensive experience. This alone could save you countless hours of frustration and thousands of dollars. While markets change, the basic tenants of human nature remain the same. You need someone within the marketplace to help you interpret what’s occurring. I am that person. As a successful Realtor since 1986, I have an insiders perspective of the current market coupled with past market experience. My guidance and input can help you make more informed decisions. For those of you who are very serious about making your dreams come true in real estate I have a special program. This program is intensive and exclusive. It requires financial and time commitments on your part. This program is much more hands on and requires more of my time in helping you formulate and execute your goals. The exclusivity of this program may place you in front of real estate opportunities on a preferential basis. I will work with only five individuals at a time under this arrangement. If you are interested in this opportunity, please call me to inquire whether I have any openings. This program is best suited for those who want to be held accountable to the achievement of goals within a certain time frame. This program is NOT required for us to work together.


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“Reality Based” Real Estate Investing I hope our paths will cross in the future. If they don’t, I wish you well in your property pursuits. You can call me for any/all of your real estate or mortgage needs-not just investment property purchases. If you would like to meet and discuss my services further, I offer a free no obligation half hour consultation at my Edina, MN office. If I can help you achieve your dreams, please call me at 952-929-2577 or 612-386-7027. I can always be emailed at [email protected] . You can visit me online at http://www.johnmazzara.com. This site has links to all of my websites. MORTGAGE AND REAL ESTATE WEBSITES You can visit my mortgage company website directly http://www.ventureloanapp.com You will find mortgage information and calculators and rate quotes. Begin your online property search at my real estate web site http://www.selling.mn. Remember, the real estate site ends in .mn If you visit the mortgage and real estate websites, don’t forget to enter the sweepstakes! BLOGS My two real estate blogs entitled “Twin Cities Real Estate News” can be found at: http://realtownblogs.com/johnmazzara or http://www.TwincitiesRealEstateNews.com

NEWSLETTERS Please visit the following links if you would like to subscribe to FREE newsletters: Real Estate Cyber Tips http://recyber.com/cybertips/r11627 My Home Management Newsletter- Real Estate & Tax Tips http://www.HomeManagementNewsletter.com YOU Magazine-Venture Development’s Mortgage Newsletter http://www.VentureDevelopmentNewsletter.com Free reports regarding buying and selling a home http://www.moving.mn


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FREE RENTAL PROPERTY WEBSITE Customizable Free Start Page with FREE hosted websites for family photos, selling a car or landlording. Advertise your rental property easily (obtain a free rental property website where you input your pictures and descriptive text. Now all you have to do is advertise that link.) http://www.mystartpage.biz/794

LINK TO ORDER THIS BOOK Please pass this link on to anyone who you think might have an interest. http://www.RealityBasedRealEstateInvesting.com


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“Reality Based” Real Estate Investing TESTIMONIALS HERE IS WHAT OTHERS HAVE SAID ABOUT MY REAL ESTATE AND MORTGAGE SERVICES:

1) We have trusted John with all of our real estate transactions for the past 20 years. Not only has he helped us buy and sell four homes in addition to a recent commercial acquisition, but he has taken the extra step in alerting us of better financing options in between our buy/sell transactions that has saved us countless dollars. It is that extra step that he has taken for us over the years that encourages us to recommend his services to our friends and family without hesitation. We look forward to continue working with John on all of our future transactions as we know that he will continue to work hard and smart for us as if he was doing it for himself. Thank you John! Steve and Vicki M

2) I have hired John as a mortgage broker in 2003 and again since then. John is a pleasure to work with. His wide breadth of expertise in different industries and depth of knowledge in all of these industries is unbelievable. I'd definitely recommend John for any of his services. Tim L

3) John's professionalism and knowledge base for all aspects of real estate-selling, financing, and preparing to sell property-went above and beyond my expectations for a real estate agent and broker. Top Qualities-Personable, Expert, High Integrity Mara P

4) I have known John for almost 30 years. During that time I have conducted real estate transactions (including using his company to acquire mortgages on homes and rental properties) with John and also consulted him on financial planning and business matters. I have always been completely satisfied with the service that he has provided. His extensive knowledge and hard work ethic, and positive “can do” attitude has contributed to many successes in my life. John is one of the most honest persons that I know and


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“Reality Based” Real Estate Investing there has never been any doubt in my mind that he has my best interests at heart. I look forward to many more successful ventures with John in the future. Mark M

5) John-You have recently sent us a "Thank You" card. This is no doubt good business, but absurd. We owe you the "Thank You"! You gave us good advice, you worked with us to get the job done, and provided a good time table assessment. You made the sale (trade) of our home a breeze. We think of you as a valued family friend and enjoy your company whether there is business to be gained or not. We hope you feel the same way! Stay as kind and congenial as you are. Tony & Jeanne H

6) John-Thank you for your great advice through the years-you've been a guiding light on our financial road! Carolyn & Chris B

All testimonials are available on file and available for review.


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APPENDIX


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“Reality Based” Real Estate Investing QUESTIONS AND EXERCISES YOU MUST COMPLETE BEFORE YOU BEGIN BUYING PROPERTY LIFE GOALS What do I want to accomplish within one year? Don’t write it down unless you believe that it is achievable. It may be better to under estimate and over deliver on your goals than to do just the opposite. Once you write it down, it should be a personal contract with yourself. You must now do whatever it takes to complete the task you’ve set for yourself. Don’t put it in a folder and forget about it until next year. Put in on your wall next to your desk so it can be viewed daily. Internalize your goal.

What do I want to accomplish within five years? Your goals are like building blocks. It is one property at a time. I assume your goal is to ultimately have financial independence. What would you do with your life if you were financially independent? What if your rental portfolio replaced your income?

What are my lifetime goals? Is it more time with the family? More time to travel and enjoy life? What about leaving a legacy?

What am I willing to give up achieving my goals? Be honest with yourself. Regarding real estate, make sure those most affected by your new foray into real estate are in agreement with your goal and will allow you to pay the price for success. Reality check-with everything there is a cost. What price are you really willing to pay? Will you work like no one else will for 10 years to live like no one else can for the rest of your life? Let’s face up to the facts so that you are not disappointed later.

What activities do I need to do daily to achieve my goals. It has been said that it takes 30 days to develop a new habit. Write down the new habits and activities that will become part of your daily routine. Goals are achieved one step at a time. Put the building blocks in place. Time and tide wait for no man. You have one life to live. Choose a life of no regrets. Remember that regardless of how you spend your time, time will pass. Make the right choices.


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REAL ESTATE GOALS-this must be completed before looking at properties! Be specific, include a definite time line for their accomplishment, and write them down. Goals must be reviewed daily until their achievement is a commitment to take action. For example, “I will buy one single family investment property every 12 months from the day I start actively searching for property. I will start my search on December 1st. I will do this until I reach my goal of five properties.”

Take an inventory. What are my overall assets and liabilities? Take an inventory of what property you currently own. Create a balance sheet reflecting your assets and liabilities so that you have a net worth statement. This exercise transcends your real estate and encompasses your other investments and total over all liabilities.

What do I like about my current real estate holdings? If you don’t own rental property already, see if you can identify what your ideal portfolio would look like. You may need to think about the future properties as you use your current property as a point of reference.

What do I dislike about my current holdings and what would I like to do differently? Be specific. Is it the age of the building? What about the location? If you don’t own property then try to identify what you know you don’t want to be involved with. Knowing what you don’t want will help you identify what you do want.

What would an ideal portfolio of properties look like? Identify the type of property and area you want to focus and build upon. Visualize and put down on paper what you are going to strive to build.

What do I want my investment to do for me-generate cash flow, appreciation, tax benefits? Set your strategy in place when you go looking for your properties. Each property may do something different. This allows you to focus your energies on the properties that are doing what you want to accomplish your goals.


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How am I going to achieve my goal? You will need a list of activities that will become part of your routine. Is it checking the court house foreclosure records? Maybe it is looking at email and viewing listings from the MLS daily. Are you committed to learning more and more about investing?


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Reality Based Real Estate Investing| Minnesota Homes For Sale

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