I Buy Houses: The Property Investor's Handbook

Introduction

I wrote I Buy Houses because family and friends were always asking me for real estate advice: ‘Should I get into the property market now?’, ‘How do I buy a property?’ and ‘How much should I pay?’ When you look at the approach that most people use to buy a property, they attend open inspections every weekend for months on end, and eventually they get fed up and buy anything. They spend a lot of time and effort, but it is the wrong approach. I spend the bulk of my time at my desk; I focus on research, not inspections, and achieve a more effective outcome while expending much less time and effort. In this book I’m going to show you how you can do this too.

In addition, there are the things that family and friends should have asked me about real estate but didn’t. Most people do not understand how real estate works as an investment or how to make money with it. They think the way to make money in real estate is to buy below market value, or buy a run-down property and then renovate it and flip it for a profit. No, I make money in real estate by spending time in the market, and augment my returns by timing the market.

Who is this book for?

The people who will find this book useful are divided into two groups. Firstly, there are the people looking to buy their first home. None of the real estate investing books provide a detailed ‘how to’ guide to buying a property. I include a step-by-step guide to the buying process — with a comprehensive example of one of my recent purchases — to address this gap. The second group are property investors, both new and experienced. Other real estate investing books mostly focus on finding motivated sellers or positive-cash-flow properties. However, the market conditions for these strategies no longer exist. Instead, I explain my value approach to investing in real estate, a strategy that is universal, timeless and makes common sense, but also requires hard work. When I say ‘hard work’, I mean that it is not palatable work for many people. In terms of physical effort, it actually requires much less time and effort than most other strategies.

Who am I?

What are my credentials for writing this book? Well, I don’t have a ragsto-riches story to tell. What I do have is nearly 20 years of experience investing successfully in the real estate and stock markets, combined with the rigour of a corporate background in pricing and financial analysis. Why is this important? Well, firstly I am equally successful investing in the real estate market and the stock market, therefore I do not preach real estate all the time. As you will see later on, this is very important because there is a right time to buy real estate and there is a wrong time, and the difference can mean having a profitable portfolio of properties working for you or struggling to hold and service an overpriced property.

Secondly, I am a property-investing expert. I have bought and built many houses, in different states and over a number of cycles. So I know the boom times when most novices mistake luck for skill, and the down times when they question the merits of investing in real estate, and how to deal with both.

Thirdly, because I have invested successfully in the real estate market for so long, I know what works and what doesn’t. For example, I have found that if you cannot get a standard loan then you are probably better off renting rather than buying a property.

Finally, I was a senior manager in a large corporation and I have an MBA, so I know how to manage businesses profitably, and investing in real estate is a business. For example, I explain how it is usually the boring things that make me money, while the ‘sexy’ things often cost me money. In addition, my background in pricing and financial analysis has helped me to understand how real estate price cycles work, how to manage them and how to take advantage of them, and I will show you how to do this too.

I buy houses...

I Buy Houses is divided into five parts. ‘Real estate basics’ forms the foundation for the rest of the book and will bring new readers up to speed with the fundamentals of real estate. Next, I explain my SYSTEM T™ investment framework that forms the foundation of every buying and management decision I make with my real estate portfolio. Then I go through ‘The buying process’ in detail (with a comprehensive example provided in the appendix). I follow this with a section on ‘Managing your properties’, which covers property management, renovation, some advanced material on property development, and selling. Finally, I wrap up with ‘Making money in real estate’, including the common real estate investing strategies, how I make money in real estate using the value approach, and the stages of development of a real estate investor.

I started writing this book 10 years ago when I began to make some decent returns in the real estate and stock markets. As I grew, so did the book, and it has been a work in progress ever since. Over time I found that investing became quicker and easier, and it was then that I realised that I had mastered the principles of successful investing in the real estate market. These principles form the basis of my SYSTEM T™ framework, my buying process and how I manage my properties, and they will act as guideposts on your investment journey.

I wish you all the best with your investing.

Paul Do

Sydney

December 2008

Part I:

Real estate basics

Real estate has created more millionaires than any other form of investment because it provides high returns over the long term and most people have a significant investment in it. Australians have one of the highest rates of home ownership in the world, and as a result many are becoming millionaires as their homes increase in value.

I have included the basics on real estate in this section as this forms the foundation for the rest of the book. Even if you are familiar with some of the material, I recommend that you still go over it for completeness. Here I cover the advantages and disadvantages of investing in real estate, the different characteristics of the real estate market, and the important concept of median prices.

Chapter 1

Advantages and disadvantages of real estate

Over the years, I have found that the easiest way to make money from real estate is to maximise its advantages and avoid the disadvantages (where possible). The main advantage of real estate is that it allows you to borrow a lot of money to fund the purchase due to its high security. Real estate also offers high returns over the long term, and there are many other advantages that we are also going to look at in this chapter. The main disadvantages are high transaction costs, high holding costs, low liquidity and lumpiness, which mean that taking a long-term view with real estate is essential.

The main advantage of real estate is that it allows you to borrow a lot of money to fund the purchase.

Advantages of real estate

The advantages of real estate include high returns combined with high security that allows investors to borrow more. Let’s have a look at these and the other advantages of real estate.

Leverage

You can borrow more to fund real estate than you can any other asset because of its high security. This allows you to have a bigger asset working for you, so you can achieve your financial goals faster.

Returns

Over the long term, real estate has returned around 10 per cent per annum in capital growth and rental yield, before holding costs (see ‘High holding costs’ in the next section). This return is comparable to shares but is more than bonds, cash and inflation. It is important that the long-term returns from real estate are higher than the returns from bonds and cash, because it means that the returns from real estate exceed your borrowing costs over the long term. It is also important that returns from real estate exceed inflation so that you can at least maintain your standard of living.

Security

Unless you overextend yourself, it is very difficult to go bankrupt with real estate because there will always be demand for shelter. It is this security that affords high leverage.

Familiarity

An often-overlooked advantage of real estate is that everyone is familiar with it as an owner, renter or boarder. The more familiar we are with real estate as an asset class, the more likely we are to invest a meaningful amount of money in it for the long term. Most people are less familiar with shares and, therefore, have less money invested in this way.

Forced saving

Another advantage of real estate is that it forces disciplined saving through leverage. People with a large mortgage tend to refrain from splurging on things they do not need until they have reduced or paid off the mortgage. When you start on your investment journey, the amount you save is more important than the returns you make. Over the long term, the returns you make become more important than the amount you save. Through the power of compounding (see below), investors who start early can invest less but still be in a much better position financially than those who start later.

Table 1.1 shows the power of compounding when you start early. Mary invests $100 each year from the age of 21 to 28, a total of $800. John, on the other hand, invests $100 each year from the age of 28 to 65, a total of $3800. Assuming that both Mary and John are able to earn a return of 10 per cent per annum, at retirement Mary will have a portfolio worth $2730 more than John’s ($42 775 versus $40 045), despite investing $3000 less than John. The reason for this is that by age 28 the return from Mary’s investment exceeds the investment and return John makes each year ($114 versus $110, and then $126 versus $121, and so on). So in effect Mary is investing more each year than John is.

Table 1.1: the power of compounding

Value add

Real estate has the added advantage (that shares do not) of allowing you to add value through refurbishment. For the experienced investor, cosmetic renovations as simple as tidying up the yard and repainting can add thousands of dollars to the value of a property. This can be important when you are starting out and have limited funds and the value of your time is lower. However, I have found that this advantage tends to be overrated because people forget to take the opportunity cost of their time into account.

Disadvantages of real estate

Real estate also has some disadvantages, the main ones being high transaction and holding costs and lumpiness.

High transaction costs

The round trip cost of buying and selling a property can be around 10 per cent of the property’s value (see ‘Transaction costs’ in chapter 4). This is significantly more than the cost of buying and selling shares, which — depending on the size of the order — is only around 0.2 per cent for a round trip.

High holding costs

The holding costs of investing in real estate can be around 20 to 30 per cent of the rental income each year (see ‘Holding costs’ in chapter 4). In contrast, the costs of investing in shares are much lower, and are mainly research-based.

Lack of liquidity and lumpiness

The lack of liquidity and lumpiness are significant disadvantages of real estate. It can take weeks or months to buy or sell a property, as opposed to a few seconds for blue-chip shares. In addition, real estate is hindered by its lumpiness — you have to buy or sell the whole property, and not just, say, one bedroom. These disadvantages can be mitigated by planning ahead and taking a long-term approach, such as adopting a buy-and-hold strategy as opposed to a flipping (or trading) strategy.

Inefficient market

The real estate market also has the disadvantage of being inefficient, unlike the stock market. In an efficient market, prices reflect all available information. This does not happen in the real estate market for two reasons. Firstly, information on specific properties is not widely available. Two-tier marketing, where out-of-area investors are charged a much higher price than locals, is an example of this. Secondly, even if the information were available, many buyers (especially owner-occupiers) would still transact with their hearts instead of their heads.

Since the real estate market is inefficient, the buyers that do the most research will achieve the better returns. This is one of my two key investing principles, the other being you should only buy real estate when market values are less than intrinsic values (see ‘Fundamental analysis’ in chapter 6).

Chapter 2

Characteristics of the real estate market

The real estate market can be described in a number of different ways. Each characteristic provides an insight into how the market works and how to participate in it. The most commonly considered characteristic of property is location. The real estate market can also be classified according to land, houses and apartments, type of ownership, property age and architectural style of houses.

Let’s have a look at each.

Location

Unlike the stock market, the real estate market is location-dependent. The state economy drives the property market in each state. For example, while the Sydney real estate market peaked in 2003, then declined and moved sideways until 2008, the Perth market rose strongly off the back of the mining boom during this period. Furthermore, different states have different stamp duty and land tax rates (see chapter 9), and council rates vary from suburb to suburb.

Most of Australia’s population resides in the capital cities in each state. The biggest capital cities are Sydney, Melbourne and Brisbane on the eastern seaboard. Perth, on the western seaboard, is catching up rapidly due to the strength of the mining boom, although this slowed down in 2008. Sydney is the most expensive Australian city measured on a house-price-to-income multiple, as it is a global coastal city that dominates its geographic location, like New York and London.

Within a capital city, properties are divided into concentric rings radiating out from the central business district: the inner, middle and outer rings. Prices typically start to rise in the inner ring, and then this ripples out to the outer rings. Satellite cities are suburbs within a capital city with significant business districts. In Sydney, they include Parramatta to the west, Chatswood to the north, Hurstville to the south and Liverpool to the south west. In Melbourne, they include Dandenong to the south east and Werribee to the south west. Satellite cities provide job opportunities, which is a significant driver of house prices. Outside of the capital cities are the regional areas.

Start with the big picture

One of the first things I did when I started investing in real estate was to get a foldout map of my capital city from the local motoring association and stick it onto the wall to get a bird’s-eye view of the suburbs and their proximity to the central business district, satellite cities, transport, schools and shops. As I diversified my investments interstate, I did the same with the other capital cities.

Capital cities vs regional areas

The majority of Australia’s population lives in the main capital cities:

Sydney has a population of over four million people, and is the corporate and financial capital of Australia. It contains the headquarters of more than half of Australia’s top companies and the headquarters of many multinational corporations.

Melbourne has a population of almost four million people and also houses the headquarters of many of Australia’s largest companies and multinational corporations.

Brisbane’s population is just under two million. It is the headquarters of some medium-sized and smaller Australian companies, although most major companies have offices in Brisbane.

Perth has a population of around one and a half million people, and is at the heart of the China-led mining boom, controlling around 80 per cent of Australia’s mining and energy projects.

Adelaide has over one million people, and its economy is based on manufacturing and defence.

The remaining capital cities contain over half a million people combined: Canberra has a population of over 300 000, followed by Hobart with over 200 000, and Darwin with over 100 000.

Apart from location, the key difference between the capital cities and the regional areas is that they support different industries. Services and manufacturing dominate the capital cities, while the regional areas are usually supported by either agriculture or mining. Over the last century, there has been a significant shift in the composition of Australian industry, from agriculture and mining to services and — to a lesser extent — manufacturing. The percentage of persons employed in Australia in agriculture and mining shrunk from 26 per cent and 6 per cent respectively to 5 per cent and less than 1 per cent respectively over the last century.¹

As a result, there has been a significant population shift in Australia over the last century from the rural areas to suburbia and the coast (from the bush to the block and the beach). Government projections show that the population of most inland areas is expected to fall further over the next 25 years, mainly due to the loss of working-age people to the cities. The rental yields on properties in the regional areas are higher than in the cities to compensate for the lack of growth. However, out-of-area demand over the last decade has pushed down rental yields and many of these properties are now negatively geared.

When you are starting out you will not have much money. It is very tempting to invest in the regional areas because property prices are so much lower. However, investing in the regional areas is a risky long-term strategy that could prove to be false economy. Properties in regional areas, like small-capitalisation stocks, are less efficiently priced than those in the capital cities because there is less attention from buyers, so you might be able to pick up a bargain. The downside is that you do not have local knowledge and could end up buying the lemons that the locals avoid. However, even if you manage to buy a bargain, you could find that a bargain in a declining market will still underperform an average investment in a strong market (see ‘Sell if long-term demand declines’ in chapter 20).

A less risky approach that I took to get into the property market was to buy a house in the outer suburbs of a capital city. Not only are prices more manageable, but the properties in the outer ring pay a higher rental yield (offset by lower growth), which helps you to service the loan. However, unlike the regional areas, the outer suburbs of a capital city are unlikely to experience future population decline. The people who live in the outer suburbs do not generally work in the CBD but in the satellite cities. While they have to spend more on petrol and there are fewer facilities, this is more than offset by cheaper housing costs.

Investing in the regional areas could prove to be false economy

Warren Buffett, the legendary investor who has returned over 20 per cent per annum over 50 years, bought his home in Omaha, Nebraska, in 1957 for $31 500. In 1971, he bought a beach home in Laguna Beach, California, for $150 000. When commenting on property taxes in 2003, he estimated the Omaha home to be valued around $500 000 and the beach home around $4 million. The capital growth of the Omaha home was 6.2 per cent per annum, while the capital growth of the Laguna Beach home was 10.8 per cent per annum. Although Omaha’s economy is much stronger than most regional areas in Australia, the capital growth of the Omaha property was just over half of the Laguna Beach property.

Another attractive alternative I considered was buying an apartment in the middle suburbs. This has the same characteristics of a house in the outer ring: affordability combined with high rental yield. Furthermore, unlike the regional areas, the middle suburbs of a capital city are unlikely to experience future population decline.

Land

Put your money in land, because they aren’t making any more of it.

Will Rogers

Will Rogers is right. For example, Sydney is bordered by the Pacific Ocean to the east, national parks to the north and south and the Blue Mountains to the west. When the available land runs out, the only recourse is to increase the density of the land use by building townhouses and apartments in place of houses on big blocks of land. With demand constantly increasing due to population growth, investing in land would seem a sure thing.

Land has the highest capital growth because they aren’t making any more of it

In 1974 an investor paid $184 000 for the corner piece of land of the Optus building in North Sydney. He sold it in 1988 for $7.2 million for a return of 30 per cent per annum.

The problem is that on the income–growth spectrum, land is to the extreme right. It has the highest capital growth but generates no income. This creates three problems. Firstly, there is no rent to cover the interest cost. Secondly, because land does not generate any income, you cannot deduct any expenses incurred in holding land against other sources of income. Therefore, you have to fund all of the out-of-pocket expenses yourself, instead of having the tenant and the Tax Office chip in. Thirdly, lenders are usually reluctant to lend against vacant land, so you have to put up most or all of the funds yourself.

The best returns from vacant land occur when there are zoning changes or subdivisions of land. Property developers either land bank (buy undeveloped land) or use options to acquire land in advance of their actual need to keep prices from increasing and to minimise their holding costs. These strategies are out of reach for ordinary investors in terms of both cost and opportunity. Investors can participate in the growth potential of land by investing in houses — which have high land content — instead of apartments.

Do your research beforehand

I was young and inexperienced when I bought my first property. Having had some success with shares, I decided to consult a few financial planners to see if they could add anything to my wealth-creation strategy. They all suggested that I diversify my investments and invest in new apartment developments to maximise my tax deductions. I only realised later that the reason the financial planners did not recommend investing in established houses was that there was no developer to pay them a commission. I had never lived in a unit before and felt uncomfortable with the lack of land content, so I decided not to follow their advice.

As an alternative, one financial planner suggested buying land and then building a house on it. For introducing me to the builder, the builder paid the financial planner $2000, which was included in the building price. The financial projections the financial planner produced looked good on paper, but I knew that it was only as good as the assumptions supporting the projection. Remember, garbage in, garbage out. I checked the key assumptions such as the cost of similar-sized land and the rental yield of established properties around the neighbourhood. Once I was satisfied with these assumptions, I decided to go ahead with the arrangement. Fortunately, I got first pick from a land parcel that had just come onto market and chose the middle block on the top of a hill in a quiet cul de sac as it had the most frontage.

The land developer delayed the exchange of contracts for the land by eight months because he wanted to defer the income to the next financial year. However, the price was locked in. This was a blessing for me, because during this time the price of the land rose by 50 per cent based on recent sales. While waiting for settlement, I decided to go and see the other house designs my builder had available. After browsing for a few minutes, I found the design of my investment property. When I added up the cost, I was shocked to find out that the financial planner had overcharged me by $12 000 ($14 000 less the $2000 commission). I asked the sales manager to explain the discrepancy. She could not, and offered to write out another building contract for me.

I learnt two valuable lessons that day. Firstly, do all of your research thoroughly beforehand, and secondly, always get at least a second quote. Getting a second quote is especially important for new investors who do not have a feel for reasonable prices and can easily be ripped off. Apart from being inexperienced, the reason I was so blasé about doing my research was that the key performance indicators were good. The relative rental yield was high and the total cost (land and construction cost) was comparable to the surrounding established properties.

Houses vs apartments

The real estate market is commonly divided into houses and apartments. Around 75 per cent of all dwellings in Australia are detached houses, which is high by international standards. This proportion is gradually declining, with semi-detached buildings and apartments making up one-third of all new dwellings completed each year. The distinguishing feature of apartments is that they do not have their own private grounds but usually share a common entrance foyer, stairs, lifts and grounds. New South Wales has by far the highest proportion of apartments, with around two-thirds of all new housing construction being medium and high density, followed by Victoria and Queensland, and then Western Australia and South Australia.

Houses and apartments cater to different types of people. High-rise apartments are suitable for singles and couples with no children. They are usually located in the inner city and near railway stations, close to cafes, restaurants and business districts. Maintenance is low because apartments do not usually have any private grounds. Houses located in the suburbs are more suited to young families, with plenty of space for the children to run about. Most of the people who live in apartments are renters, while most who live in houses are owner-occupiers.

Land content

When considering a house or an apartment you must take into account the land content. This is important because only the land component appreciates over time. This is due to increased demand over time from population growth for a fixed supply of land. Buildings depreciate over time through wear and tear. Houses have the most land content, followed by duplexes and townhouses, and then apartments.

Land appreciates, buildings depreciate.

Another advantage of houses due to their high land content is the scope for higher use (subject to council approval), such as dual occupancy and redevelopment into apartments. As we run out of land, the only solution to meet increasing demand is to increase the density of the land by converting houses into townhouses and apartments. When this happens the house owner usually makes a windfall gain. However, this is a long-term phenomenon, and even in the inner city it might take many, many years for the land to be rezoned.

The higher use of land can result in windfall gains

An aunt of mine was fortunate to benefit from the higher use demand for her land. In 1997, she and her husband bought a run-down house for $174 000 in an area surrounded by units. That was all they could afford at the time. The block was later rezoned, and in 2002 a developer paid my aunt and her neighbours $600 000 each for their properties to consolidate the land and build new apartments. The market price for similar houses was only around $350 000 without the rezoning premium.

Growth vs yield

There is an inverse relationship between capital growth and income yield. That is, the higher the income yield, the lower the capital growth that can be expected from an investment, and vice versa. Houses have higher land content and therefore have higher capital growth over the long term. Since apartments have lower land content and therefore lower capital growth, they are priced to provide a higher rental yield than houses (see figure 4.9 on p. 61). The advantage of a higher yield is that it allows the buyer to service