Most people in Northern CA started investing in real estate by buying their own homes. And most have made money as real estate in Northern CA has continued to appreciate in value. So when they move up, they decide to rent out their first homes. And then they acquire a few more homes. They know they have negative cash flow but make a profit because of appreciation. This is the typical story how most real estate investors invest in residential properties. So far luck has been on their side.As the interest rates have gone up gradually in the last 12-24 months while the rents in the Bay Area remain very much flat, the negative cash flow gap is widening. The risk for investing in residential properties is increasing. The same old formula of investing may not work anymore. In the best case, investors may still make money but not as much in term of percentage since the value of real estate is pretty high already. In the worst case, investors may lose money as residential real estate may remain flat or even decline in value. Is there a solution for real estate investors in Northern CA? Of course, these investors can use the same old formula in a new area that has potential for appreciation. So the key is to find this new area. They just have to talk to someone who knows this new area. It could be Bakersfield or Sacramento or Fresno. Alternatively, investors can put money in commercial properties: retail strips, shopping centers, medical office buildings. Let’s just explore this paradigm shift to see if it makes investment sense.1. Income: commercial properties generate 50 to 200% more rental income compared to residential properties in the Bay Area. In addition, there is no rent control for commercial properties. So landlords can charge your tenants as much as the market permits.2. Leases: in general commercial real estate leases are more favorable to landlord compared to residential leases. Besides the base rent, tenants also have to pay landlord for property taxes, insurance and all maintenance expenses. These leases are called Triple Net or NNN leases. Because of this type of lease, commercial properties are better maintained than residential properties. Besides, the NNN leases also take away a lot of risks from the landlord as maintenance costs are unpredictable. On the other hand, landlords tend to defer maintenance on residential properties to reduce the cost. Consequently, the deferred maintenance will have negative impact on the value of the properties.3. Better Tenants: tenants for commercial properties are financially stronger. They may be Walmart or Home Depot with billions of dollars in the bank. They are less likely to nickel and dime with you. In addition, they also guarantee the lease with their assets. If for some unforeseen reasons they have to vacate the property, they continue to pay the rent or find another tenant to sublease it. They are also motivated keep your property in good condition to attract their customers to their stores. While majority of residential tenants are good, some think once they pay the rent they have a license to trash your properties and then disappear in thin air with no forwarding address!4. Long term lease: commercial tenants are less likely to move. They often sign 5-10 year leases. Tenants like Walgreens, and Walmart sometimes sign 20-50 year leases. In contrast, residential leases are short term. They could move out to a new place a mile away to get a $25 rent relief! It’s a fact that the turn over rate for residential tenants is very high compared to commercial tenants. As a landlord, this gives you more unneeded migraine headaches and stress.5. Management: It’s much easier to manage a 10-tenant shopping center than 10 individual homes in 10 different places. As a matter of fact, if you own 10 residential rentals your tenants most likely have worn you down and we are exhausted. They often move out in the summer just around the time you want to take off for vacation. Yes, it’s a fact that residential properties are very management intensive because of high turn over rate. If you have to hire a property manager, it also costs more in terms of percentage of the rent to manage residential properties. Besides, it probably is a full time job just to manage these 10 property managers!6. Income Tax Returns: it’s much easier to keep track of records for income tax purposes for a 10-unit shopping center than 10 separate residential rentals in several states. You just need to have one file for the shopping center while you will need 10 folders for 10 residential rentals. The task becomes more challenging as the IRS requires you to keep records for several years. Your out-of-state income tax return is also thinner for a 10-unit shopping center than 10 residential rentals.7. Tax Write-offs: commercial properties offer the same tax write-offs, 1031 exchange as residential rentals.8. Credit Scores Impact: most people don’t know that once they have about 10 residential mortgages, their credit scores will start going down. The credit bureau reasons that credit risk is higher the more money you borrow and 9-10 mortgages seem to be the threshold. On the other hand, commercial mortgages have no negative impact on your credit scores as these mortgages are not reported to the 3 credit bureaus.9. Pride of Ownership: most commercial properties are referred to by name and not by their addresses, for example Lion Plaza, or Valley Fair Shopping Center. They could be trophy properties that offer enormous pride of ownership. You get lots of respect when you tell people you own a certain shopping center they know.10. Investment size: commercial properties often require substantial amount of money so it’s not meant for someone with a modest amount of money.So if you want to work hard for your money or bet on appreciation then invest in residential. If you want to work smart, go after commercial properties. Commercial real estate investment is a more prudent way to invest in real estate if you have more equity for down payment. Each month you have strong positive cash flow so you don’t need to rely on just appreciation to make money. So if you have not invested in commercial real estate, you now know why you are not among the elite group of real estate investors. You probably wonder where you should go from here if you want to explore this possibility further. In the coming issues, these topics will be discussedo Which commercial property should you invest?o Where should you invest in commercial real estate?o How to pick and choose a good commercial propertyo What you should know before hiring a property management companyIf you cannot wait for those articles, you can sign up for a free seminar about Commercial Real Estate Investment at Transmercial. San Jose Real Estate Investor Club (phone number 408-264-3198) occasionally offers a similar seminar for a small fee.

Investing in PropertyWhat is the best way to buy rental property?The question you need to ask yourself is – Am I buying this property as an investment?Now this sounds like a pretty stupid question, right? But in reality, many people (myself included) have made a purchase decision on the basis that they love the “property” not the “investment.”What do I mean? Well you have to stop and ask yourself do I really love investing in property or do I just love to own property. Many have purchased an “investment property” on the basis that they “liked” it, rather than because they had calculated it would provide a great return.When investing in property you should always run your numbers through a property investment calculator before deciding whether to even look at a property, let alone buy it!My first CBD apartment – aka “Investing in Property for Fools!”I’d always wanted to own a piece of the CBD. Growing up as a kid I loved visiting the “city” to look at the skyscrapers and imagined coming here for work like my Dad did each morning. Sure, I was investing in property. I was investing my emotional security in a property location! So you can see quite clearly that it was an emotional, rather than a hard headed decision to buy a newly complete one bedroom unit back in the early 2000s. It was just something I’d always wanted to “have.”I remember driving around the inner city with a well known property spruiker looking at projects he was involved with. Of course his level of involvement was as a master salesman. A unit became available for approximately $230k. As a young couple my wife and I discussed the pros and cons and I decided against the advice of my wife that this might not be such a great idea.At the same time another unit had become available in the inner city block of apartments that I was currently living in. It was available at a similar price. My wife counselled me to consider this as an option. My “adviser” had discouraged me on the basis that I would be putting all me eggs in one basket. There was some truth to this advice so I followed my “dream” of an apartment in the “city”.When I went to the office to sign the papers I remember being advised that the original unit was no longer available, but a different one on a higher floor was, at a higher price! I said OK, No problem, like we Aussies tend to do. Then I was presented with the option to purchase a “furniture package” for an extra $20k. This would “guarantee” a rental return of 8% to me for the first 2 years of my investment. I hadn’t previously considered this, but of course I said “Yes”and was told what a wise choice I had made. (Of course this made me feel good about myself!)The truth was I bought the unit not on the basis of its potential financial return but its immediate emotional return. I never did end up living in it or even spending a single night there, although I’d often wander past and gaze up at my balcony and wonder how “cool” it would be to live here.In fact the property was a complete drain on my bank balance due to the high costs associated with the common areas including pool and gym equipment. The rent never paid for the outgoings and I lived in hope that the price would go up so I could make a “paper” profit at least!Now some time later I did end up selling the unit for around $300k, so it was far from a complete disaster. In the end I was very glad to sell and call it even. In reality the cost to me was an opportunity cost. What else could I have been doing with my money? I looked recently for sales data on the city block in question and found a similar unit sold for $355k, approx. 10 years after my initial purchase. Currently in the inner city block I was living at, prices are over $650k. Remember that 10 years ago these properties were selling for approximately the same price. If I had listened more to my wife and less to my own emotion I might have ended up $300k better off!What did I learn? I learned that whilst it’s great to listen to “advice”, be aware that sometimes advice might be just a little biased! I’ve learned to trust my own instincts more and weigh advice against what I already know to be true and reasonable. The reason I liked the apartment in my own block was that it was located well. It was quiet, had views, was close to city, walk to tram, bus and train and there was no high-rise in the vicinity. The area couldn’t be quickly re-developed and units added. In short, the amenity was desirable and there was not going to be any new properties added in the foreseeable future. This meant there was a cap on supply.In the city here is not a cap on supply. There are numerous developments under construction at any given time. I’d be more than happy to live in many of them. But I wouldn’t buy then as an investment! Unless they were in a landmark building of some sort there is no scarcity value in them. They can be replaced easily.If one of your neighbours wants to sell and needs to move quickly, guess what. They set the price for your unit. You have virtually no control over the market. No matter what you do to your own living space the whole value of the block will be determined by factors outside your control.Investing in Property for cashflow or for growth?Let’s be honest. Most of us are investing in property because we think that prices are very likely to go up! On the other hand we all know about “negative gearing”. In essence it means we can write of our “losses” on our investment against other area of income. I don’t disagree with the concept, we ought to be able to weigh our profits against our losses and pay tax on the net result. BUT, if all we own are “investments” that are make a “loss” and we’re offsetting that against a “gain” from our job, that’s not really smart investing is it? Sometimes a property might be increasing in value at a greater rate than we could expect to make as a cash income from our investment. This is not always the case as you can see from my experience in the Melbourne CBD. But at what point does this cease to be a valid reason for deciding to invest of even “keep” and existing investment? Steve McKnight from PropertyInvesting.com once said something very illuminating at an event I attended. Basically he said we ought to do an audit of our property portfolio every year and re-assess whether we ought to hold or sell each property!Seriously. I never thought I was going to sell anything – Ever!Early on in my property journey I’d decided I was going to “Accumulate” property. Buy and never sell! That was my motto. Once I’d paid down the loan I would be sitting on a nest egg and having rent more than cover my outgoings.But consider this! Real world example -My unit in inner Melbourne right now would be worth about $650k and yet it might command a weekly rental of around $480. That’s about $25k rental annually.The yield is therefore 25k/650k annually or 3.8% of the value.Setting aside things like mortgage repayments, there are still fixed costs on any property – In my case they include for the last financial year:Council Rates $820
Water $945
Insurance $302
Owners Corporation $1660
Agent fees $1815
Repairs $890
Total fixed expenses for the year $6430This reduced the total income to ($25000-$6430)=$18570Now my actual annual return is 18.5k/650k = 2.9%Of course costs like Agent fees and Owners Corporation are not always applicable but they serve to show that in the real world the actual return can be a lot less than a simple headline figure.If I include my interest costs (which still exist) I must deduct another ($150000*6%)=$9000 from my income.This reduced the total Real income to ($18570-9000)=$9570Now my actual annual return on the asset value is 9.5k/650k =1.5% Should I Sell this property?There is no right or wrong answer. Sometimes I say yes and my wife says NO! Sometimes I say No and my wife says NO! Do you see a pattern here?There is no right answer because everyone has different needs, has different skills and is coming from a different base and most importantly – We all want different things! It depends on your circumstances, your family situation, the personalities of you or your partner and your goals in life.If our main goal in life was to increase our cash on cash return or all our assets then it would be a no brainer to sell up and invest elsewhere (assuming I could expect a greater return than 1.5%!) Having said all that I still love property, and I love investing in property.It’s quite possible to love the idea of property without loving investing in property. In fact most property that you’ll “love” will probably be pretty darn useless as an investment. Don’t be confused.Would I choose to invest $650k of my actual cash in this investment right now of it were available for sale? Probably not! – So why am I still keeping it? I love it and plan to live in it.This is a question only YOU need to ask yourself and answer on a case by case basis. I’ve looked long and hard at my own situation and decided to keep for now based on family reasons, NOT investing reasons.Review every property every yearFor every investment I currently hold I review the property and make a decision based on the real numbers, not a fantasy of what I’d like to see happen.That’s why I decided to sell my apartment in the Melbourne CBD.
It was “Costing” my money to hold, and NOT growing in value anything like I’d hoped it would. So I cut it off.
It was why I needed to sell my first home out in the “burbs”.
It was why I made a similar hard decision to sell a property in inner city KEW that was returning a reasonable cash return, and well located but had ZERO capital growth over ten years.
It was one of the reasons I sold a great apartment in Sydney’s North. I had improved it and added value. It was time to take my money off the table.Your relationship with a property needn’t be a marriage for life. There’s no compulsion to “stay together” till death do you part!.What about Cashflow positive real estate?I love cashflow positive property and investment strategies. So Yes, I look to see where the cash if flowing and see how I can get if flowing towards me.Think! Are you buying for lifestyle or for investment? What return are you hoping to achieve? Only when you can answer these questions honestly are you ready to take action!Until Next time,