Investing in Income Properties: The Big Six Formula for Achieving Wealth in Real Estate

Introduction

The country is in an economic crisis, primarily because of the collapse of the housing market. This has caused tremendous financial losses in the stock market and the banking industry. In mid-March 2008, Standard & Poor’s issued a statement estimating that write-downs for large financial institutions on subprime debt would hit $285 billion (Subprime Write-Downs Could Reach $285 Billion, But Are Likely Past The Halfway Mark, March 13, 2008, on S&P’s Web-based data service Ratings Direct). But this does not represent the end of the housing market in this country. It will eventually come back, and when it does, it may be stronger than ever.

Good quality income properties in top locations remain vibrant and healthy – and these are the kinds of properties that I spotlight in this book. They comprise apartment buildings, small shopping centers, office buildings, and industrial properties.

As far back as I can remember, the demand for top-grade properties has always exceeded the supply – and it is no different today than it has been in the past. These types of properties are hard to find because only a small percentage of owners will sell them. However, buying one of these top-grade properties does not guarantee that you will make money. That will come from those properties among them that meet the Big Six criteria, which is the focus of this book. The Big Six is a formula that I developed many years ago. Using it will virtually ensure your success and bring you great wealth, just as it has done for me.

I started my own career with nothing, and over the past 30 years I have bought and sold $300 million in income-producing real estate. It was because of my drive and adherence to the Big Six formula that I eventually became financially independent. I am going to share with you the strategies and techniques that brought me success throughout my career. And I will also tell you about my setbacks. By the time you finish reading this book you will have the tools to achieve your own success—most likely in a shorter period of time than it took me.

I realize that this book will be read by a wide spectrum of people, including investors and potential investors, some with a small amount of cash to invest and others with substantial financial resources. I will be principally dealing with income properties in the price range of $500,000 to $5 million. Additionally, I will be using the terms income properties and commercial properties. They are synonymous, as are net operating income and net income.

The public and the media think of real estate as homes and condominiums, but real estate is much more than that. The best kept secret in America is that fortunes are being made every day in income-producing real estate—not just by the rich, but by people who started off buying little apartment buildings, neighborhood shopping centers, small office buildings, and clusters of small warehouses. They started investing in a single $500,000 building, with as little as $50,000 to $100,000 in cash, and then began to buy more and more buildings.

Ride up and down any street in the country and observe the small commercial buildings that dot the American landscape. These buildings are not owned by real estate moguls but by entrepreneurial people who got the bug to become owners of income-producing real estate. They knew that commercial properties would give them far more impressive returns—and with less risk—than any other type of investment. Their goal? To become wealthy enough to live the lives of their dreams without having to work.

The book is divided into three parts. The first part reviews the basics and how to get started. It explores how income-producing real estate is superior to other investments. Most people have fears of investing in the commercial real estate market because it is unknown territory for them. I outline how to overcome those fears. And it is in this part of the book that we explore how to assemble the cash resources you’ll need and where you can find the most effective educational resources as you work to become a savvy investor.

Also in the first part of the book, you will learn how to bring together a first-rate team of professionals to provide needed expertise and counsel regarding your real estate investments. Among them are the right real estate broker, attorney, and accountant. Each will prove invaluable in helping you build a portfolio of wise investments.

New investors, as well as those unhappy with the results of their past investments, should spend time soaking up the lessons provided in the opening pages. Experienced investors may know a lot about the basics, but a review can reveal new insight. As with a good golfer or tennis player, it pays to revisit the fundamentals.

In the second section of the book, I detail the criteria for identifying the right buildings to buy. These chapters contain the most important advice you’ll ever receive, including how to finance deals with the most leverage and the best rates of return. Adherence to the Big Six formula will build your equity, cut your income taxes, and help you escalate the return on your investment. My play-byplay examples of Big Six transactions demonstrate the fine points of negotiating price and revenue considerations. They will help you understand exactly how each element of the Big Six meshes with the other components for a no-fail deal.

The third part of the book focuses on moving forward with your investment after you have closed the deal. There are many people who have never invested in commercial real estate because they say that they don’t want to become landlords. They don’t have to! Most successful investors do not personally manage their own properties. What most investors do is to hire a professional management and leasing company that handles everything for them. The cost of hiring such a firm usually pays for itself. Professional managers know the market inside and out and can, in many cases, increase income and reduce expenses.

The conversions of large rental apartment complexes to condominiums were the craze from 2003 until 2007. Hundreds of thousands of units were converted to condos. This came to a virtual dead end in 2007. However, when one door closes, another door opens. In the next-to-last chapter of the book, you will learn about the incredible amounts of money that can be made—with virtually no risk—via condo conversions of small apartment buildings.

One Good Investment Is Worth a Lifetime of Labor, is the title of the closing chapter of the book. This is where you will read the personal stories of six investors, each of whom became a multimillionaire from just one investment. They all started with very little money of their own.

Throughout this book I will refer to the fact that you make your money in buying—and I’ll tell you why. I will also emphasize that, if you adhere to the Big Six formula, you can, within a relatively short period of time, continually increase your rate of return—to 10 percent, 20 percent, 50 percent, 100 percent, 1,000 percent, and eventually to an infinity return, which is the ultimate goal of any investor. An infinity return is so great that it is immeasurable and incalculable.

This book is designed so that you will understand what it takes to become a successful real estate investor. You won’t do it overnight or by being lucky. But you will be successful if you put into action the principles and strategies of the Big Six, which will give you the tools you need. The road to riches is open to you. Seize the moment—and enjoy the journey.

PART I

THE BASICS

A notable portion of the population has been through at least one real estate negotiation—buying a home—and many have changed their residences more than once. Despite that, too often people don’t understand the nuts and bolts of a real estate deal. That’s not entirely their fault. Real estate is not taught on a regular basis in high schools or many universities. And, in recent years, financing tools have changed dramatically. Now there are many different kinds of mortgages and a long laundry list of mortgage terms. On top of that, there is an abundance of real estate advice floating around, much of it misleading or just plain incorrect.

In the case of commercial real estate investment, the old adage is wrong, because what you don’t know can hurt you. Fortunately it’s not hard to learn the fundamental principles of how real estate transactions take place and the terms used within the industry. (The glossary at the end of this book can help.) Easy as it may be to learn, however, you won’t pick up the essentials when you’re already in the middle of a deal. It is imperative that you have a grasp of real estate basics before you get going on your own investment portfolio.

The most important part of this book is the Big Six formula, the core concepts that will put you on the path to riches. However, before we jump into that formula for success, we’re going to review the nitty-gritty of buying properties, the terminology you’ll need to understand, and other essential workings within the world of real estate investment. Chapters 1 through 4 tackle these, starting with an explanation of why real estate offers greater wealth-building opportunities—with much less risk—than stocks and other investment vehicles. We’ll also look at the sequence of steps in a real estate deal, the expert professionals you’ll need on your real estate team, and, finally, how you can access enough money to get started.

Certain investment elements—such as zoning laws, contractual agreements, and construction standards—will vary from state to state and even city to city. But the basics remain the same everywhere in the country. Before you risk your investment, take some time to clearly understand what you’re doing. If you do, you’ve set your stage for success.

CHAPTER 1

Why Commercial Real Estate?

Americans work, work, and work. A study by the Economic Policy Institute shows that worker productivity in the United States has risen 33 percent over the past decade (The State of Working America 2006/2007 by Lawrence Mishel, Jared Bernstein, and Sylvia Allegretto). Yet many Americans have little to show for it. Only a small percentage of people achieve financial independence by the time they retire. The rest spend their retirement years surviving on pensions and Social Security benefits. For younger Americans, even those often-inadequate safety nets are becoming precarious. Increasing numbers of companies are abandoning pension plans as an employee benefit, and the beleaguered Social Security system faces an uncertain future. Because of those realities, people must shift the way they think about the future. They must take the initiative to invest now in order to live the way they want later. Instead of working for their money, their money should be working for them.

Commercial real estate investment is a powerful way to make that happen. And it is easier than you think. In fact, if you can master just half a dozen important keystones to property investment—the Big Six formula—you can put yourself on the road to real estate success.

What you really need as you enter the world of commercial real estate is an understanding of how to make wise investments. This book will help you comprehend the ins and outs of a real estate deal, why finding the right property to buy is the most crucial part of your investment, what the Big Six formula is, and how you can master its steps. Why real estate is the way to go and why too few people pursue this option is the focus of this chapter.

Real Value, Real Ownership, Real Estate

The goal of real estate investment is to increase your net worth, strengthen your income, and achieve financial independence so that, if you eventually choose, you can stop working and begin living the life of your dreams. Different people have different financial goals. You could aspire to a net worth of several million dollars with a very substantial annual cash flow. Your cash flow is the money remaining in your pocket after deducting operating expenses and mortgage payments from gross rental income. Or your goal may be to achieve a $1 million net worth with a more modest cash flow. It depends on your particular needs, wants, and circumstances. That said, all investors—regardless of their financial objectives—need to learn the same strategies for identifying and taking advantage of opportunities.

You may already be saying: I don’t have enough money to invest. This is a misconception. It’s true that the majority of salaried workers or professionals, whether they make $50,000 or $1 million per year, spend most of it. Then-Federal Reserve Chairman Alan Greenspan created a stir when he told Congress that U.S. residents in 2004 saved only about 1 percent of their annual income (Testimony of the Chairman Alan Greenspan at the Federal Reserve Board’s Semiannual Monetary Policy Report to the Congress before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, Feb. 16, 2005). Since then, the statistics have become even more alarming. The personal savings rate has fallen below zero. This is the lowest rate since the Great Depression and one of the lowest of any country in the world. (By contrast, the personal savings rate in China is about 30 percent.) The upshot is that Americans live from paycheck to paycheck and borrow—usually with credit cards—to get through tight times.

That may not sound promising for would-be investors seeking to enter the real estate market. But those statistics hide something important: Although savings rates are falling, the net worth of many Americans has been rising, in part because their homes have increased in value and, in some cases, because stock market investments have stabilized. This means that even without savings, most people have assets that can be turned into cash to get them started investing in real estate. You may have money available without realizing it.

Real estate is not the only place to invest, but it holds advantages over other investments. The stock market is volatile. But the volatility of the market is what brings the biggest return on investment. The higher the volatility, the higher the rewards may be, although the risks are also higher (as is the potential for crushing losses). Many factors come into play in the stock market other than the performance of a corporation. World events can affect the market. Just think of what happened on Wall Street after the 9/11 terrorist attacks or how the market fluctuated wildly during the so-called Asian Crisis of 1987; also consider the more recent turmoil in the Mideast caused by the war in Iraq. One bit of news in one single day, either in this country or anywhere else in the world, can cause havoc in the stock market and horrendous losses. Not so with real estate.

Mutual funds may be promoted as a way to diversify investments and establish a safe portfolio. A lone mutual fund may hold securities in hundreds of companies, meaning it is less susceptible to a single company’s problems. The funds may also allow people to begin their investment with as little as $500. But the value of a mutual fund fluctuates and it has no guaranteed return. Furthermore, because a mutual fund is tied to the performance of the stocks in the fund, it could depreciate in value. At the same time, the fees, sales commissions, and administrative costs for the funds can offset some potential returns.

Bonds, meanwhile, tend to rise and fall less dramatically than stocks. That means they are more stable and carry lower risk, but they also carry a low rate of return. When you invest your money in bonds, it is tied up for a period of time. If you sell a bond before it matures, you may find that it’s worth only what you invested or even less. These disadvantages are not normally associated with commercial real estate investments.

There are other investment vehicles, such as money market funds. They are solid and secure, but they are best used to help investors preserve what they already have, not to grow wealth. Inflation may sometimes even outpace these investments. So that brings us to commercial real estate. It is not without its risks, but if you’re knowledgeable about investing in income properties, you can maximize your return while minimizing your risk. And your real estate investments, particularly well-researched investments in income-producing properties, can prove impervious to other economic ups and downs.

The Control Factor

One of the strongest arguments in favor of commercial real estate over other investments is that you’re able to control your own financial destiny. People who invest in stocks think nothing of turning their money over to someone else, then hoping for the best. Mutual funds are also managed by professional portfolio counselors. But with real estate, you remain in the driver’s seat.

Your control over your investment manifests itself in many ways. For starters, you get to see exactly where your money is going. You can do a physical inspection of the property you’re buying—see it, touch it, feel it. You can also judge on your own the value of your investment, negotiating the price of your property both when you buy and when you sell. And you make the important decisions about financing and refinancing, including the terms under which each deal is structured.

Beyond that, you decide who will manage your properties. That’s an important advantage over the stock market, where you must trust corporate executives and board members to make decisions in your best interest. And just as you oversee the management of your real estate investment, you’re also able to maintain your own books on the investment. As a stockholder, you can see a corporation’s quarterly earnings or read through its annual reports, but you won’t have open access to the books. With real estate, the books are in your hands.

With this level of control, you can maximize efficiencies. You have the freedom to decide whether, when, and even how improvements and renovations are made. You negotiate the leases to your properties based on your wishes and priorities. And you use your discretion to decide when the time is appropriate to make changes, including rent increases or decreases. This flexibility is important. This is your investment. You should have a say over how it is handled.

Financing Options

When it comes to the array of financing options available, real estate has no competition. Banks, insurance companies, pension funds, and other entities that finance real estate investments offer a wide range of terms and conditions on their loans. As a result, the opportunities to find something that matches your financial situation are numerous. You don’t need volumes of ready cash. There are mortgage loans available that allow you to borrow 80 percent (and in some cases, 90 percent) of the value of a commercial property based on amortization periods of 25—and sometimes 30—years.

Once you begin shopping for loans and comparing the terms offered, you’ll see that the differences can be quite amazing. In Chapter 9, we’ll explore in depth the strategic importance of how you finance your income-property purchases.

The Leverage Edge

Leverage, one of the most significant advantages of investing in real estate, refers to the practice of using a minimal amount of cash to buy a property while financing the balance for the longest term possible at the lowest available interest rate. Leverage is one of the most important tools in building wealth through investment real estate. For starters, it makes real estate affordable. Most investors couldn’t make such a significant investment if they had to come up with all the cash at once. Wealthy real estate moguls know the power of leverage.

And leverage, which is, of course, intrinsically linked to the ability to borrow—or access money that is not your own—carries another important advantage. While interest rates on home mortgages have been low, homebuyers generally have no room to negotiate the amount or the terms of the mortgage. In commercial real estate, negotiating the right loan is part of the deal. Commercial financing is discussed in detail in Chapter 9.

Leverage is an extraordinary tool that exists because lenders believe in the stability of choice income properties. They recognize these properties as solid investments. For investors with a strong credit rating, they are happy to make loans for up to 90 percent of a commercial property’s value, provided it is a choice property in a top location. I know of no other investment where you can put in as little cash and get as high a rate of return.

Tax Benefits

Income-producing properties carry special tax advantages. Land is not depreciable, but the buildings that sit on it are. Under the concept of depreciation, the Internal Revenue Service assigns a useful life to buildings, 39 years for commercial property and 27.5 years for residential property, including apartment buildings. The assumption is that as buildings get older, they decrease in value each year. But when properly maintained, most buildings actually increase in value over time. Depreciation is a bookkeeping expense and not an out-of-pocket expense. Therefore, if you have a net income from a building of $100,000 and the depreciation is $30,000, the net income now becomes $70,000. If you are in the 25 percent tax bracket, you will save $7,500 in income taxes ($30,000 × 25 percent = $7,500).

In the foregoing example, you may be able to substantially reduce your taxes on the net income by using a method known as segregated cost depreciation. Under this method, the IRS will permit you, based on a qualified engineering report, to divide the cost of the building into four components. One component would be the building itself (the real estate), based on either a 39-year or a 27.5-year useful life. The other three components can be classified as personal property based on a 6-year life, a 7-year life, or a 15-year life.

Because of the faster tax write-off under the preceding formula, your depreciation reduction would be significantly higher during the initial seven years of ownership using segregated cost depreciation. And that would reduce your income tax obligations dramatically. If you have already invested in real estate and haven’t used this method of depreciation, you can go as far back as 1986 and calculate the additional depreciation you could have taken under segregated cost depreciation. You can state it as a deduction on your current income tax return without amending any previous returns. If you are a real estate professional (not necessarily a broker or agent) and active in the operation of the building, you can take any losses generated by depreciation as a deduction against your ordinary income—which lowers the amount of income tax that you pay. The resulting income tax savings would, in effect, increase your cash flow and, accordingly, your cash-on-cash return.

Paul White, a prominent real estate broker and educator in South Florida, states, One of my clients who acquired 10 properties over the last 12 years was able to reclassify approximately 23 percent of their depreciable value of $25 million and realize an income tax reduction of over $1.5 million on their most recent tax return.

Meanwhile, exchanging one investment property for another investment property defers capital gains taxes until a subsequent property is resold (1031 Exchange). Those are just examples of the many tax benefits that are available on real estate investments. Later, as we explain different financing options and property sales approaches, we’ll also discuss their tax advantages.

Access to Information

Real estate is an investment characterized by openness and quick access to information. Real estate sales are part of the public record, so it’s easy to track sales histories and the financing details of a particular property. Local and national property listings, sales of tax liens, details on sheriff sales, and foreclosures are among the volumes of information available on the Internet. There are public records on how neighborhoods are zoned, and Census Bureau information