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Amassing a personal fortune through real estate may seem beyond possibility, but it can be done — personally building a private equity real estate firm from the ground up has taught me that much. If you’ve built up a nice nest egg yourself and are wondering what to do when the next crash comes, how to position yourself for a boom or a bust or where to look to find a solid real estate investment deal, remember to keep it simple and pay close attention to these three basic concepts.
1. Maintain Conservative Ratios
If you’re building or buying real estate as a long-term hold, make sure that property is going to cash flow very well, even if that means you utilize more equity and accept a slightly lower return. Debt-service coverage ratio (DSCR or just DCR) is calculated by taking the net annual cash a property produces and dividing it by the total annual payments for any/all debt on the property. So, if a property will generate $100,000 per year after all expenses such as taxes, maintenance, vacancy, etc., and you put a loan on it where the total monthly payments for the year equal $50,000, then you have a 2.0 DCR.
A 2.0 DCR may seem overly conservative, but when over-leveraged owners get in trouble, equity evaporates, and banks can foreclose, leading to a total loss of capital. I like to say that real estate experiences temporary setbacks. If the market drops and you have plenty of cash, you might have to accept a lower return on equity for a while, but you won’t lose the asset to foreclosure. Then, when the market rebounds, all your equity will come right back.
Remember, accepting a lower return and/or keeping cash on the sidelines will serve you very well when the time comes. Not losing money is often better than making a huge return. Over time, not losing will be a better strategy than always chasing yield — because eventually, almost all highly leveraged individuals and/or companies will take a big tumble.
2. Location
I know, location is traditionally said to be the three most important things, so maybe this should be No. 1 on this list. Stay close to town, close to services and close to the right level of wealth/money. For instance, don’t try to locate a low-income housing project in Beverly Hills, and don’t build $2 million condominiums in Alaska (unless maybe there’s a ski resort or something there I don’t know about). The point is, your properties blend in with their surroundings. This is not a place to try to be the one who bucks the trend.
3. Supply And Demand
This concept is equally easy to quantify and easy to avoid or not pay attention to — I see it all the time. Here’s the scoop: Find the information, and pay attention to it. Are there more projects coming to the area than there is demand for? If it’s even close, move on. Believe me, even a top-notch yoga studio and gourmet coffee shop aren’t going to earn an extra $200 per month in rent or fill up or sell your units if there’s no demand for them. That’s where many find themselves right now. Development is starting to run rampant, and people are working to justify their deals because they think their projects are better than the four other similar ones going up. But whether they’re better or not is not the right question. The right question is: “Are there enough buyers/renters/tenants to fill up all current deals as well as any others in the planning phase?”
If you are investing in a project or looking to create one, don’t underestimate the importance of being conservative, making sure it your location is right and paying close attention to supply and demand.