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Cost accounting reveals most real estate investors lose money on most of what they do

Posted by John T. Reed on

Cost accounting tells a typical company something like this: You are overall profitable with your 20 products, but after examining your business with a microscope figuratively speaking, we must tell you that only 20% of your products are profitable. Eight are around breakeven and another eight are losing money. Your belief that everything you are doing is profitable because it is overall profitable is incorrect is an example of the ignorance-is-bliss phenomenon.

You need to either make the 16 unprofitable products profitable or discontinue them.

Now let’s apply that to real estate investing. Many novices seems to be collecting as many cash-out refis, LLCs, and separate buildings as possible and some are overall profitable when they sell after five years or so.

So is everything they are doing profitable? Hell, no!

Call option

About the only thing they are doing that is profitable is acquiring a sort of perpetual call option at the purchase price.

The typical real estate investor is engaged in the following services:.

A. Acquisition—can be profitable if you make a bargain purchase like buying a foreclosure; most are not even trying to do that. If you do not do that, acquiring a property is a time-consuming and money losing activity.

B. Rental property operation—generally negative cash flow if you have a mortgage, extremely time-consuming (about 3.6 hours per unit per month), high risk of litigation.

C. Sale of property—100% money loser; large transaction and tax cost—can be zeroed out buy never disposing of a property

D. Exercising a call option—A call option is the right to buy a property at a fixed price for a period of time. An option is “in the money” when the value of the property exceeds the call option price after transaction costs. This is where real estate investors who think everything they do is profitable are actually making their only profit. It is done by them not using the call option terminology or deal structure of an option per se. Rather, by buying the property they fixed their price at that time and when they later sold at a higher price, they, in effect, cashed out their “call option.”

So a cost accountant would advise the investor to knock off activities A through C on the grounds that they are time- and money-wasting activities. Just purchase, then exercise, call options.

Real world?

That is a theory. Can it be done in the real world? Yes, in a fashion. For one thing, you can do it as such. I have seen some sharpies buying call options by characterizing it as a way for property owners to access their equity without borrowing. Maybe the hundreds of thousands of cash-out refi addicts at internet real estate investor groups would fall for that.

But the more likely trick would be something line this: buying tenant-in-common interests or judgments.

Widow dies. She leaves everything equally to her three kids including her free-and-clear home. Bob and Barb already have homes, but the black sheep of the family, Babs, does not and moves into the home. She ought to pay fair market rent to the other two siblings, but does not. They should pay their thirds of the expenses, but they do not. Babs is still getting to live there rent-free and mortgage-free.

Bob and Barb are not happy, but they cannot really do anything about it.

Letter to TIC owners

You get a mailing list of all tenant in common owners in your area (from assessor’s records) and send them all a letter which says:

“You own a TIC. I buy TICs. I know of no one else who does. I will pay you all cash for the one you own. If you do not wish to sell now, please put this letter where you keep your important real estate papers so you can contact me later if you change your mind.”

For various reasons, like a business opportunity or a financial emergency, some TIC owners will want to sell. You buy at a big discount. If the owner balks at the discount, they can sell to someone else, but there is no someone else.

Many will decide they would rather keep it than sell that cheap. Fine, you do not have enough money to buy them all. You buy from those who would rather have a lesser amount of cash now than wait until Babs is willing to sell off her free ride.

Buying judgments is another similar strategy that makes you part owner of a property.

Letter to your fellow owners

After you acquire a TIC or judgment, you contact the other owners of that property—Bob and Barb in this example. You send them a letter.

“I own X% or $Y of your property. You can buy me out or sell out to me. Or you can do nothing. If you do nothing, you will have to buy me out if you want to ref or sell the property at that time. Or I may file a partition lawsuit to force a sooner sale of the property.”

Until one of these event happens, you own real estate, but you are not having to manage it or collect rents or repair it or any of that. Babs is doing all that. You should insure your interest. If Babs has insurance, you could offer to pay your third of it in return for being named an additional insured. Or you could buy your own insurance. You have an insurable interest.

Plus back rent

When there is a refi or sale, you are entitled to your % share plus your share of the net rent (fair market less operating expenses—essentially the positive cash flow an owner would have received on this free-and-clear house) since you bought the TIC or judgment amount plus interest.

You acquisition costs are minimal. You spend no time or money on managing the property. Litigation risk is minimal because the home is owner occupied by Babs, a one-third owner. Basically, you just acquire it then wait. One day, a title company will ask you for a pay-off statement on your interest in the property. All you do is acquire the TIC on the front end then later sign a payoff statement and closing documents. Roughly as if you had purchased a call option, then exercised it.

That is smart investing. Collecting cash-out refis, LLCs, and as many separate properties as you can is a waste of time and money for the most part. What I Just described isolates the profitable part.

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