Where Do All the Profits Come From?

Buying real estate is easy. Becoming financially independent doing it is another story. To begin with, many investors simply don’t under­stand where profits come from or what they must do to produce them. Many are of the opinion that proper timing is the most important ingre­dient in making real estate millionaires. Others think patience is more important for success: simply buy choice properties in an appreciating market and sit back and wait. “You can’t go wrong,” they say.

Playing the Appreciation Game
The biggest question for real estate investors who bet on appreciation is what happens if there is none? Worse yet, what happens if property values drop? Real estate is a cyclical business: prices and values go up and down. Betting on short-range appreciation is like shooting craps—you can sometimes double your money overnight, but you can also lose the ranch just as quickly.

Reaping the benefits of appreciation without having to worry about timing is a much safer strategy. Real estate will almost always increase in value over time. For example, consider a three-bedroom, single-bath house in Sacramento, California that cost $20,000 new in 1968. It reached a high value of $181,000 in 1992 and then dropped to $160,000 by the end of 1994. For short-term-profit investors, most of the ’90s have been declin­ing or stagnant years. However, over the long haul, that house in Sacramento has appreciated nearly $5,400 each year since it was built.

Appreciation Should Be the Bonus

Appreciation should be a plus for the wealth builder, not the whole plan. If you view it as a bonus, you don’t have to worry about short-term up-and-down cycles. Instead, you can concentrate on how to make much bigger profits in the long-term.
To begin with, you need to understand that most wealthy real estate investors buy more properties than they sell. Selling properties, especially when you’re just starting out, is like digging a deep hole and then filling it back in. The reason is because the minute you sell a property, your investment stops earning you money. Worse yet, any gains or profits you might make are immediately taxable. Obviously, paying taxes and building wealth don’t go too well together.

Double the Value by Fixing ’Em Up

Let’s say I’ve learned about the sale of 10 junky little rental houses on a half-acre lot near the edge of town, suffering from poor management and rundown conditions, which always means low rents and deadbeat tenants. Let’s assume I offer to purchase the property at 5.5 times the gross rents of $325 each, or $3,250 per month totals, and the owner accepts my offer. That means I will buy the property for $214,500, or $21,400 per unit (12 times $3,250 per month equals $39,000 annually, times 5.5 GRM for $214,500).
Let’s also assume that I can fix up the property and upgrade the ten­ants for about $3,000 per unit, including all the cleanup work and materi­als. I estimate it will take 12 to 18 months to do this job myself and to turn the property around. Property turnaround means getting a better class of tenants and establishing good property management policies.

It’s not my intent here to discuss how much the down payment should be or where to find fix-up money. Rather, let me simply say with regard to both that down payments are substantially less and terms are substantial­ly better with low GRM deals. Figure 12-1 will give you an idea of the terms and conditions you might expect for various 10-unit properties with GRMs ranging from 4.5 to 9.5. Now, imagine the profits when you make a two-point improvement in the GRM, which will yield significantly higher rents and an overall increase in the property value.

Do-it-yourself investors should keep in mind that labor amounts to approximately 70% of the total fix-up cost. In this example, we said fix-up costs would be $3,000 per house—or a total cost of $30,000 (10 x $3,000 = $30,000). That leaves material costs of $9,000, which must be paid as you do the work and purchase materials. I’ve found credit cards are ideal for spreading out the expenses. Just be sure, if you decide to use them, that you can pay the monthly bills.

Looking Good 18 Months from Now
Finally, when the job is done, everything looks spick-and-span, with nice green lawns (revived weeds) and white picket fences. The jacked-up cars are gone now and regular paying tenants occupy your units. Everyone agrees—the property looks great now. It’s clean and the location is perfect for renters who need to be near shopping and schools. The nearby pizza parlor is an added bonus. With your GRM improved by 2 points, rents are $440 per month and worth every nickel. Your personal fix-up efforts have added value to make it happen.
The Magic of Compounding
Compounding real estate equities works the same way as your savings account, only better. That’s because you can use something called lever­age to speed up the moneymaking process. We’ll talk more about leverage later, but first, I want you to fully grasp the power of compounding.
Compounding means earning interest on both the principal and the accruing interest. As it keeps growing over time, the results are simply astonishing. Most wealth builders are amazed when they discover how quickly money grows and multiplies. The following example serves to illustrate the power of compounding.
If you deposit $1,000 into your bank account every month for 20 years, never draw any money out, and earn 12% interest on all your deposits, plus the accumulating interest—that’s enough to make you a millionaire (well, almost!). You will end up with $989,255 in your bank account at the end of 20 years.
Saving $1,000 a month might sound like a ton of money when you’re just barely making ends meet. But $12,000 a year is not really a huge amount anymore. Many folks have mortgage payments twice that amount and vehicle expenses that equal it.

How can just 20 years of investing $12,000 a year make you a million­aire? After all, 20 years times $12,000 is only $240,000. Where does the rest of the money come from? It comes from the 12% interest compound-ing—and all you need to do is make your $1,000 deposits and leave the money in the bank. In 20 years, the interest alone adds up to $749,255. Compounding is very powerful—and it will do the same thing with $1,000 worth of real estate, only better.
Killing the Golden Goose
The magic of compounding comes from leaving your investment alone. In other words, if it’s money in the bank, leave it there and don’t touch it. If it’s four rental houses, don’t sell them for a short-term gain. I must warn you right now—the short-term profits you earn will never be enough to make up what you’ll lose in the long run if you break up your compound­ing cycle.

Disturbing the cycle in the early years will cost you dearly. I’ll show you why. At the end of the second year in our 20-year investment plan, the accumulated amount of principal and interest earnings would be approx­imately $27,000. If you withdrew $10,000 of that amount, it would result in a $230,000 loss by the end of the 20 years. Your accumulated total would only be $757,860, just because of that withdrawal of $10,000 in the second year of the plan.

In later years, as compounding builds and the dollar amounts get larg­er, withdrawing $10,000 slows down the earning power much less. For example, in the 17th year, the account balance would be $661,300 and will grow to $757,800 in the 18th year. If you were to borrow $10,000 at this point, it would hardly be missed, because the annual earnings would have reached nearly $100,000. During the 20th year, the account will earn $123,000, which is more than half the total amount you invested through­out the entire 20 years.

Buying properties to fix up and sell for quick turnover profits might seem like a great idea to some. But it doesn’t help you build the lasting kind of wealth most investors are seeking. This is because selling does not allow long-term compounding to work at full strength. When you con­stantly buy and sell properties for short-term gains, you wind up losing a ton of money in the long run, as our example shows. Withdrawing $10,000 in the second year costs $230,000 in the long run.
Four Ingredients That Produce Profits
In order to maximize compounding, you’ve got to select the right vehicle to get there. Not just any properties will do. There are four basic ingredi­ents that produce profits:
Cash flow earnings
Tax shelter benefits
Equity buildup
Appreciation or inflation
Keep each one in mind as you search for the right investment.

1. Cash Flow Earnings
Cash flow is the most important benefit for any investment. Without it, you’ll eventually be forced to sell the property or, worse yet, you’ll lose it. Cash flow gives you the freedom to keep your property through ups and downs in real estate cycles, without being forced to sell at the wrong time. Selling in a low cycle can easily cost you $30,000 on a $100,000 invest­ment. Believe me, you don’t want many sales like that.
As a general rule, when real estate is hot, at the top of a cycle, it’s not at all difficult to sell property for 115% of the normal price. However, when the cycle hits bottom, 85% sales are more common. On a $100,000 deal, earning a 30% profit is certainly a worthwhile objective. Cash flow earn­ings of 12% are a very reasonable expectation for investors who buy run­down properties and add value to them. Don’t forget what 12% com­pounding does for your bank account.
2. Tax Shelter Benefits
Depreciation is the magic expense item that causes your property to show a loss for tax purposes, but still generate positive cash flow. The reason for this is that the IRS allows investors to deduct—as an expense item—a certain percentage for things that wear out, like buildings, coolers, refrigera­tors, and carpets. This expense is really a “phantom” expense, because you don’t need to write a check to pay it, like replacing the toilet.
The cash benefit comes from two sources. First, the depreciation expense will shelter the property income from taxes. For example, if the rental property generates $2,000 positive income, before deducting a $4,000 depreciation expense, the property will show a $2,000 loss for tax reporting purposes. Second, the same $2,000 loss against the property can be used to offset, or eliminate, taxes on $2,000 worth of income from the owner’s salary or from another income source.
3. Equity Buildup
Equity buildup adds to your wealth monthly, each time you pay the mort­gage. Although very small at first, a certain percentage of your mortgage payment goes to reduce the principal balance. With each principal reduc­tion payment, you own a little bit more of the property as the bank owns less. Typically, on a 25-year mortgage, with an interest rate of 9% and a 20% cash down payment, equity buildup amounts to something like 3% or 4% annually.
As you can see, however, there are many variables. Obviously, in those cases where only interest is being paid, there’s no mortgage pay down so there’s no equity buildup occurring. In certain situations where you assume or take over a mortgage with only half of the original payments left before the mortgage is fully amortized, principal reductions will be sub­stantially higher. But, regardless of whether mortgage payments are high­er or lower, the important thing to keep in mind is that your tenants are paying off the property for you with their monthly rent checks. They buy the property and you own it. You can’t beat that.
4. Appreciation or Inflation
Appreciation or inflation comes in two flavors.
First, there’s the kind that comes from natural causes. Everyone gets a taste automatically if they happen to own properties in an area where appreciation or inflation is happening. Sometimes it’s as little as 2% a year, but I’ve seen inflation jump to 25% or 30% for a short period of time. I’ve also watched properties nearly double in price in just two years. The prob­lem with natural inflation is that there’s no guarantee it will happen.
The second flavor of appreciation is forced appreciation—my special­ty. I can count on it to work, because I have complete control. When I buy rundown houses and fix them up, I am forcing them to appreciate. The higher value comes from being able to attract better tenants, who are will­ing to pay higher rents. I upgrade the properties so I can provide a better product to my customers (renters). On several occasions, I’ve increased the property values by nearly 100% in just 18 months of ownership. You can do the same—and when 100% starts compounding, it won’t take very long to add a couple extra zeros to your net worth. You’ll also find that smiling at your tenants becomes a little easier.

Leverage Lets You Soar with the Eagles

High leverage can make you richer faster than any investment tool I know of. The idea is to safely borrow as much money as you can to put with your own down payment (if you have one) to purchase income properties.
For example, I can gain 90% leverage when I purchase a $100,000 apartment using $10,000 of my own cash for a down payment and sign a promissory note or mortgage for $90,000 back to the seller. If the proper­ty earns $10,000 in annual rents, that means the return on my cash down payment is 100%.
The problem is, that can be good or bad. If the expenses are $4,000 and the mortgage payments are $7,000, my 100% return doesn’t mean much. I’ll still be losing my shirt.
Leverage is a double-edged sword: you want leverage that’s safe. In this example, if I can increase rents to $12,000 or negotiate a mortgage that would cost only $5,000 annually, I will then earn $1,000 on my $10,000 investment. A 10% cash flow, using 90% leverage is a very respectable return, especially for apprentice investors.
Not Everything Can Be Measured in Dollars
A rich man once said, “Money is not the most important thing in the world—but, it’s still a long ways ahead of whatever’s in second place.” I certainly won’t disagree that money is very important, but it’s not the only measurement of an investor’s success. There are many very attractive ben­efits that come with an investor’s lifestyle. Most folks, however, never get to experience them, so let me share a few with you.

To start with, I don’t need to operate my real estate business on a rigid time schedule, like most of my friends who work regular nine-to-five jobs. Since I’ve been there, I know the routine. My schedule is far more flexible. Try it—and I guarantee you’ll like my way better. Also, I’m not stuck in a dead-end job going nowhere fast or working for a nitwit boss who should be my assistant. I’m also not part of that morning madness on the free­ways, packed with hundreds of cars moving about half the speed I normal­ly walk. That alone makes it worth dealing with my tenants—who gener­ally act more civilized than early morning freeway drivers.

Brain Compounding Can Increase Your Wealth

When I started investing in fixer-upper houses, my simple plan was to buy them cheap (I had very limited funds), fix them up, and rent them out. Selling was never my first choice for making money. I always felt that hav­ing a continuous income from my investments was the best way to go. At that early stage, I was not yet aware of all the various strategies I could use to make extra money with my houses. As I went about fixing houses, I began reading all the books I could find about real estate investing. I soon learned new and different ideas about how to invest.
Reader’s Digest (May 1973) published an article by Edwin Diamond entitled “Can Exercise Improve Your Brain Power?” In it, Diamond said that through selected mental exercise, like reading, you can actually increase the capacity of your brain to make it function better. Mental exer­cise, such as reading real estate investment books and learning at semi­nars, can actually cause your thoughts and ideas to compound, much like the compounding of money.
That’s exactly what happened to me. New ideas and methods of acquir­ing real estate filled my thoughts. A good example was when I came up with the idea of “lemonading”—buying properties by using a combination of cash and personal property I no longer had any use for. It works extremely well when you find sellers who don’t want their rundown real estate anymore and are willing to trade. This technique allows a small amount of cash to go much further, like hamburger helper. It can double or triple your buying power.

Before I began reading and educating myself (brain compounding), I had no idea I could present lemonade offers and get them accepted. I never realized I could buy back my own mortgages at big discounts. When I began fixing houses, these techniques simply never occurred to me. When I look back today, I realize brain compounding has been a major contrib­utor to my accumulation of wealth.

Don’t Walk Away from Your Gold Mine

I’m aware that most new investors tend to follow the same path I did. First, they learn how to acquire income-producing real estate, and, of course, that’s a good start. However, most of them don’t follow through and expand their moneymaking opportunities. Many small-time investors miss out on real profits, similar to inexperienced gold miners who, after easily finding shiny nuggets on the surface, leave the real fortune hidden by only a few inches of sand. Brain compounding happens when you con­tinue to seek more knowledge. It will make your investment houses pro­duce far greater yields than you can ever imagine.

Adding New Profit Bulbs on My Money Trees

I often refer to my investment houses as “money trees.” I call each of my various profit-making strategies “profit bulbs.” In the beginning, I had just my bare tree with two lonely bulbs—namely, profits from my rents and, occasionally, profits from a sale. That was back before I knew anything about brain compounding, when my knowledge was very limited, and before I started reading and attending seminars.

Over the years, I’ve managed to decorate my “money trees” with many more “profit bulbs.” Obviously, the more bulbs I add to each tree, the more it glitters like gold. It’s the same old tree (fixer houses) I started with, but now, with the addition of many new bulbs over the years, my gold mine has become much more productive.
My First Profit Bulb and Best Source of Continuous Income
My first “profit bulb” has always been my rental income. Although the IRS refers to rents as passive income, I don’t—and neither will anyone else who manages tenants and collects the rents. Still, it’s my best source of continuous income every month. Once you develop your landlording skills, you can easily net 5% to 10% of the gross rents, even with leveraged properties. I once owned 216 houses with average rents of $385 per month. You can see that monthly income adds up rather quickly, even with very modest rents. It’s also important to remember that when you’re doing this correctly, tenants are actually paying off your houses for you. Realizing this has always made me feel much better at the end of a hard day fixing toilets.

Fixer Jay’s Favorite Profit Bulbs

Selling profits is certainly a bulb with a whole lot of glitter. However, as I said earlier, I still favor keeping most properties and allowing them to earn continuous monthly income for me. About the only time I’ll consider plucking a rental bulb from my tree is when a buyer gets very motivated to purchase my property, regardless of the price. Naturally, I can deal with one fewer bulb on my money tree when there are serious profits involved. This will most likely happen during a hot seller’s market or when I’m weeding out properties that I don’t think will meet my long-range profit expectations.

Seller financing is a profit bulb that will earn you a lot of money. It’s available when you sell properties and carry back the financing yourself. Interest income is easy money and takes very little effort, except walking down to the mailbox to pick up the check. You can design your carryback mortgages to be long-term when you’re ready to travel around the world or retire. Also, when you’re nervous about a buyer or the down payment is a little on the thin side, you should insist on additional collateral to pro­tect yourself. (For details, see the final section in the following chapter, “Removing the Risk from a ‘No-Down’ Sale.”)

I first started buying rundown houses, I had no idea that property owners could do this. I was in shock (but happy) when I asked for and received a $29,000 discount for simply paying off my mortgage seven years earlier than I had originally promised. That’s over $4,000 a year for doing noth-ing—you can’t make money much more easily than buying back your own mortgages at steep discounts.

Half sales are another excellent profit bulb on my money tree. Rather than selling a good income-producing property—giving up all the depre­ciation and effectively selling the goose that lays golden eggs—why not just sell half the property? That’s enough to substantially improve your cash flow. The basic strategy here is to purchase a rundown property with low rents for $100,000 and fix it up until it’s worth $200,000, with higher rents to justify the increased value. Then, sell half the fixed-up property to a passive investor for little or no cash down payment. This makes a hard-to-refuse proposition.

By doing this, I’ll wind up with a mortgage receivable for the half I sell. This means I have mortgage payments coming in every month. Also, I’ll be able to increase my personal income by collecting a monthly manage­ment fee and payments for maintenance and repair labor on the half I don’t own. This is one of the slickest strategies I know of for making neg­ative cash flow properties produce positive income. It’s an excellent strat­egy for investors who can do the kind of fix-up (adding value) we discussed in previous chapters. (You can read more about half sales in Chapter 16.)

Creating notes for down payments is a profit bulb that can make your money tree glitter even brighter when you own properties with equity, but lack sufficient cash to keep buying new ones. You can simply type up your own promissory note or mortgage—and use it for your down payment. Simple, huh?

This strategy allows you to select the note value, the amount of your monthly payments, and the length (term) of the mortgage. “How can I do that?” you’re probably wondering. It’s because you’re preparing it and it’s your typewriter—that’s why.
Many times after fixing up rundown properties, I’ve increased the val­ues from 50% to 100%. That means I’ve created borrowing equity. This new equity will be security for the promissory notes I create. For example, if I purchase a property for $50,000 and increase its value to $100,000, I created at least $30,000 of borrowing equity. I will still maintain a 20% loan-to-value safety margin, like the banks do. This technique works extremely well when combined with lemonading—where my offer includes some cash (the sugar) and something other than cash (the lemons). This combination is often irresistible to a motivated seller who can’t find anyone else to purchase his or her ugly property.

Leasing houses with an option to purchase is another of my favorite profit bulbs. I use this technique to increase the monthly cash flow for my larger, more expensive houses. The smaller houses I own have excellent rent returns without offering leases or the rights to purchase. For exam­ple, I can rent smaller, two-bedroom houses, with 600 square feet, for about $425 a month—that’s 70¢ per square foot. My nicer houses with three bedrooms, two baths, double garages, and approximately 1,300 square feet of living space will normally rent for $650. That’s only 50¢ per square foot and not quite enough income for the exposure, in my opinion.

The lease option remedy allows me to collect higher monthly rents ($800 to $850 range) in exchange for giving potential buyers (optionees) a higher than normal rent credit back toward the purchase price if they exercise the option. My leases are for three-year terms and my selling prices are generally somewhat higher than appraisals. I have never yet met a house buyer who can tell whether the value is $95,000 or $105,000. I’m sure I don’t need to tell you which price my option contract will specify.
Buying discounted notes or mortgages is another high-profit bulb on my money tree, one that I accidentally discovered along the way. Buying discounted notes or mortgages can be a potential double-barreled oppor­tunity for hands-on fix-up investors like me. The reason is because I would always prefer to own the property that secures the note or mortgage rather than owning the mortgage. If I should take the property back for nonpayment, I’ll also get the rental income and tax shelter, plus a 40% dis­count the day I take over. You couldn’t possibly design a better purchase deal than that.

I have two questions I must answer for myself when I have an oppor­tunity to buy a note or a mortgage:

Would I be happy to own the collateral, the property that secures the note?
Is there an adequate equity cushion, the difference between the prop­erty value and whatever is still owed against it (total mortgage debt)?
If my answer to both questions is “Yes,” I’m always happy to move for­ward with the deal and purchase the note. Obviously, there’s a good oppor­tunity for me to earn even bigger profits should the note default and I end up foreclosing, as discussed above.
My debt limit rule for income-producing properties is 65% loan-to-value. That means that if there are three existing notes or mortgages on a $100,000 property and they add up to no more than $65,000, I’m general­ly willing to purchase any one of the notes at a reasonably discounted price. As you can see, buying discount notes or mortgages is really two profit bulbs in one. If everything goes well, I’ll receive high-yield note payments; and if it doesn’t go well, I’m more than happy to take over a $100,000 income-producing property for 65% or less of its full market value.
Every fix-up investor should explore this profit bulb opportunity very closely, so they can fully understand what I’m saying here. This bulb can truly add extra padding to a skinny bank account, believe me.

Read Fixer-Uppers part 13

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