The Ten Roads to Riches

by Ken Fisher

  Here’s the fool’s bargain. Consider a profitable decade and place—again, San Mateo County, where I was raised. On January 1, 1995, San Mateo’s median home price was $305,083.3 Say you bought with 20 percent down (before the zero-down craze) plus 1 percent closing costs. The going rate was 7.5 percent for a 30-year fixed-rate mortgage, so your monthlies were about $1,700.4 Fast forward 10 years. You sell for the median 2005 price of $763,100, just before the market peaks.5 You’re a timing genius! Pay the $184,091 mortgage balance (after amortization payments) for a $579,000 gain. Subtract out your down payment. You have an 849 percent return—25.2 percent annualized! That’s how most folks figure real estate, but it’s dead wrong.

  First, in 10 years, you paid over $60,000 in principal. We must subtract that—should figure time-weighted payments—but to be quick and dirty, take your gain, subtract the down payment and principal, divide, and you have 379 percent, 17 percent annualized. But that mortgage wasn’t free. You paid over $247,000 in interest. Ooh! Subtract that, recalculate—it’s 174 percent, down to 10.6 percent annualized.

  Still too high. San Mateo’s annual home upkeep averages $1,820 (gas, water, other niggly details).6 Maybe you remodeled for $40,000 and added a patio for $15,000. Don’t forget your 1995 closing costs and 2005 realtor fee (about 5 percent). And property tax! In San Mateo, you pay 1.125 percent of your purchase price—boosted by 2 percent each year. Over 10 years, that’s over $37,000.

  Our quick, dirty analysis shows a cumulative 59 percent return, 3.1 percent annualized. That’s lousy. Folks see homes as their greatest asset. Truth is, it’s all leverage. You can easily fool yourself. Folks say, “Yeah, but I’d pay rent if I didn’t own. There’s value there.” True! But the greatest value of your home is the roof over your head and the satisfaction it gives you.

  Learn to properly calculate returns. There are costs few consider.

  FLIPPIN’S FOR FRIGGIN’ LOSERS

  Many want to buy and sell, flipping real estate for a fast profit. Don’t. Fact is, real land barons don’t flip. The transaction costs are just too high. They focus on an internal rate of return—providing monetized profits while the land appreciates.

  Take Timothy Blixseth (ex-billionaire, now appealing a fraud conviction).7 He flipped. Before his huge success, and before the housing crash (and shenanigans) brought him down in spectacular fashion, he screwed up huge early on. An 18-year-old Blixseth wanted a fast way out of his poverty-stricken youth. So he pledged his life savings of $1,000 as a down payment for $90,000 worth of Oregon timberland he saw in a newspaper ad. Why timber? He came from a timber town—thought he knew timber. He figured he would find a buyer and flip it. Fast. He promised the seller the rest of the $89,000 in 30 days.

  The seller knew Blixseth had no money or investors and figured to teach the kid a lesson—sell him the land, then foreclose. Blixseth needed a buyer, fast. Amazingly, his little plot abutted Roseburg Lumber Company, a large landowner. Blixseth marched in and offered to sell to Roseburg for $140,000—a relatively random amount but a seemingly fat, fast profit. They bit. Later, Blixseth learned Roseburg had long needed that land for an access road, but the seller hated Roseburg’s owner and in that way acted in his own worst interest.8 Blixseth was flippin’ lucky—nothing more.

  Smitten, he flipped more—mostly timberland. He bought remnants with minimal down payments, selling fast to lumber firms. Blixseth might hold title for mere minutes.9 He was undone by the 1980s’ sky-high interest rates and went totally bankrupt. Lost everything. He learned his lesson and flipped no more. He started again, building another real estate portfolio, this time leveraging only assets he actually kept and monetized—not assets he owned for hours. And that put him on the billionaire path—until he was accused of embezzling hundreds of millions from a luxury resort he owned and spent 14 months in jail. Don’t break the law, kids.

  Flipping got extra-sexy after the housing crash, when banks happily unloaded foreclosed homes for a song. Reality shows like HGTV’s Flip or Flop show everyday people turning roach-infested, mold-covered, trash-packed teardowns into the hottest house on the block in just two months, racking up $50,000 or more in quick profits. So easy! You could do it, too! Or not. That’s the magic of editing. In reality, typical TV flippers are backed by silent partners, do everything through a fund (read: tax shelter), have costs you don’t see, and employ armies of contractors and house hunters to keep it going. Anyone wanting to bootstrap their way to flipping success is flippin’ dreaming. Financing, construction costs, closing costs, and short-term capital gains taxes take too big a bite.

  Flipping’s a loser’s road.

  GETTING STARTED

  You’re ready. First, find an economically vibrant market. Vibrant doesn’t mean pricey or affluent—you don’t need Beverly Hills. The best places are business- and employee-friendly, where future growth continues. Jobs pay for everything. Land barons need tenants, renters, or buyers. People go where jobs are, and jobs are where prosperity is—where folks want to shop, work, live, lease, and rent. This isn’t a tough notion to fathom. You don’t need (or even want) a major city. Third-tier cities in employee- and employer-friendly areas are fine.

  How do you find such places? Research state income and sales tax rates. A shortcut: Magazines occasionally do features like “100 Best Places to Live.” An annual feature in US News & World Report titled “Best Places to Live” assessed business environments, tax conditions, and overall quality of life. They did your homework for you! You can Google it or follow this address: http://realestate .usnews.com/places/rankings-best-places-to-live.

  Then, incorporate. Or create an LLC. You shouldn’t bear risk personally—your business does that for you. Your business protects you when people sue. And they will! It’s better they sue your business, which is insurable for litigation, than sue you.

  Start Small and Unsexy

  Start small and bootstrap. (Revisit Chapter 1 for why.) You won’t have enough cash for a big project—yet. So buy a decrepit duplex, fix it up, live in half, rent the other. Then, leverage that cash flow and buy a rundown four-unit vacant apartment house. Same thing, only bigger! Fix it up a bit so you can rent it at higher rates.

  The key is finding tenants. The success formula is buying based on vacancy and creating value by filling it. If done right, it covers costs plus some. Meanwhile, your building increased in value because you filled it. It’s a little business—with inputs exceeding outputs. Do this several times, and you’ll have cash flow and a track record and can convince investors to give you capital infusions for bigger buildings—maybe condos or office buildings. Then lever that into something even bigger with greater cash flow potential. That’s it. Each time, the key is monetizing empty space that isn’t worth much until you make it more valuable.

  Find an economically vibrant area with low taxes and start small.

  The Perfect Pro Forma

  Beyond your first duplex or two, you won’t get or use bank lending. Banks are pretty leery about land baron lending. You don’t want bank lending, anyway. Banks readily lend to individuals for homes. But they aren’t big on what we have in mind. So how do you get financing? You convince outside investors to fund you with a stellar pro forma—a land baron financial model. The idea is to create a compelling but attainable plan to sell to investors.

  Like Mina, the Mini Land Baron

  Life has compromises—you can travel this road without everything being perfect. My daughter-in-law knows. She is one hot chick—UCLA Med School MD, child psychiatrist. Mina is a Korean-born, second-generation, self-made, all-American dream. Her mother came straight from Korea—worked herself to the bone supporting Mina and her brother. Mina has work ethic, moxie, and the terrific taste to love my most-excellent middle son.

  She’s also going land baron all on her own by levering her medical income to buy a beat-up old house with 13 legal but slum-like rental units in rent-controlled Berkeley. Because it was in bankruptcy with lots of vacancies, she can remodel
and raise rents. It’s just off the subway line near where her mom still works herself to the bone. So now Mina can put her mom in the house’s nicer, prime part (beautiful woodwork and windows in front), improving her mom’s plight, and her mom can help oversee tenants (no chic woodwork there).

  Then, Mina fixes it up and fills it with more desirable tenants at higher rents. Mina’s got the leverage part, the monetizing the empty part, the how to get the tenants part all figured. The only part not optimal is, it’s rent-controlled (not great) in Berkeley (communist stronghold). But Mina had to start her medical career here for a few years and couldn’t do this elsewhere. She’s doing the best she can in a suboptimal spot, but she’ll be OK. Even if you’re stuck in a suboptimal place, you can do this. But it’s better to do it where the wind is at your back.

  Buy software to build a pro forma for about $199 and up (at ZDNet.com, Download.com, or RealtyAnalytics.com). Or build one yourself in Excel if you know how to calculate amortization and depreciation. If this flummoxes you, you simply must buy the software or take a class or both—or find another road. Without a good pro forma this road is bumpy. Also, check out the Urban Land Institute (ULI; www.uli.org). ULI is a national networking support group for developers, providing classes and mentorship.

  What’s in your pro forma? Interest costs, construction, depreciation, permitting, and upkeep costs—everything homeowners forget. The water and electric bill. Property taxes. Every detail nicking your bottom line. Then make assumptions about appreciation and income. Maybe you assume 85 percent occupancy collecting X dollars each year. You envision rents rising Y percent over the decade. You depreciate the building, decreasing taxes. Run different scenarios. If X happens, occupancy increases Q percent. If Y happens, rents fall Z percent. (This is where the software helps.) Finally, distill everything to a likely internal rate of return on investor cash—this is the piece of the action you’ll offer investors in exchange for the down payment and a safety net.

  Now what? Sell, sell, sell! You’re offering them that piece of the deal, but with a huge haircut for your management—because you make it all happen. This is like OPM (Chapter 7—check that chapter for a good parallel). Good land barons are super salesmen like founder-CEOs (or pretty much every other road). Many investors will decide your pro forma is fantasy. So you figure out what’s wrong and fix it—or what’s wrong with the investors and change them.

  BUY, BUILD, OR BOTH?

  What kind of baron will you be? Do you want to build fancy new properties like the Donald, acquire existing ones, or some of both? (Actually, Trump’s father started in nonfancy apartments, handing the Donald a big bundle. The Donald grew that in the mid-1970s by buying troubled Manhattan buildings when New York was flat on its back. His fancy-new phase came later. Then came the reality-TV phase, followed by the be-president phase. The Donald hates being bored.) Build or buy, there are distinct considerations. First, consider the following.

  Location, Location, Location

  Concentrate in communities friendly to you—a rule that’s true and untrue all at once. If you don’t have political clout, you must be in a business-friendly place. If you have political clout someplace that is otherwise hostile, you can do there what most can’t. Political clout is another way to say the community is friendly to you, but maybe not to everyone else.

  Lots of people can do deals where they come from, but can’t do them in other areas. As known “favorite sons” (or daughters), they’re trusted by the local governmental authorities to do what they say they will. If you’re anyplace but where they really trust you, you need a business-friendly place or you must build political clout to overcome the obstacles awaiting you.

  A compelling but reasonable business plan is vital.

  Know Thy Code

  Whether building or buying, you must know the building codes (find them on Google) and other rules. This isn’t trivial. Rule changes can parse huge profits into total loss. You can see why Harry Macklowe (net worth $2 billion before the housing crash, now trying a comeback)10 went dynamite. He owned four old dumps he wanted to demolish to build glitzy Manhattan condos. But then-Mayor Ed Koch passed a law preventing changing this usage, believing occupants, mostly low-income renters, had no other options. At night, hours before the bill went into effect, Macklowe dynamited the buildings. He paid $4.7 million in fines and was banned from building for four years.

  Two years later, Mayor Koch acknowledged his ban was maybe unconstitutional. Macklowe didn’t wait—he broke ground.11 The city council griped he had no right—the ban still stood—but he built anyway and paid fines, creating the Hotel Macklowe. Few aspirants have his chutzpah or lawyers. So as stupid as many local building codes may seem, you must know them.

  Buying existing property can be easier—but still rules abound. True story. Since 1970, the San Francisco Armory stood empty—a whole city block in the colorful Mission district. Repeated and varied development attempts failed. Condos, apartments, stores, offices—you name it—the city refused. So it stayed empty doing no one any good. Meanwhile, San Francisco hurts for new housing supply. And new property taxes would help their budget, but no!

  What finally passed muster in 2007—after standing empty for 37 years? In the very city that first created America’s modern “adult” industry, Kink.com was allowed to put in an online adult movie studio specializing in, ahem, dungeon scenes.12 It would film them right there—in the Armory! High-end condos—no. But a world-scale porn studio? Sure! You don’t want to buy a building only allowed for porn. Or maybe you do! But know your options first.

  Know zoning and building codes cold before starting.

  WHERE TO BE AND NOT TO BE; THAT IS THE QUESTION

  Environments worse for employees and employers are worse for you. The California I was raised in was the Golden State, the one that set the trends America followed. No more. It’s losing population while losing wealthy and high-income citizens—but taking in no-income deadbeats. It may be today’s worst state to start out as a wannabe land baron. It suffers America’s most complex and often contradictory local regulations. Unlike decades ago, it now has the worst labor laws and worst judicial system for employers and employees—that’s real, social-based, and won’t go away.

  First, they constrict construction. Then—I kid you not—city commissioners write hypocritical, affronted letters to newspapers deploring how land barons’ expensive real estate prevents “middle class” families from living in their communities! The solution? Raise income and sales taxes to get the money so they, the politicians, can fix everything. Amazing!

  Right now, supply is exceedingly limited and demand unstoppable. It’s only gotten worse since this book first came out. The Bay Area has permitted just one home for every six new jobs since 2010.13 Developers are clamoring to replace boarded-up strip malls with shiny new blocks of retail, topped with hundreds of apartment units—but most proposals fall through. In one recent example, the Irvine Company tried to redevelop an old self-storage facility in Santa Clara with a mixed-use megaproject: 450 apartment units and ground-floor retail, all across the street from a transit hub. A young techie’s dream! But the city council whacked it down to 318 units and beefed up the “affordable housing” requirement. Irvine walked away—capping construction meant capping revenues. No profits there!14 Now instead of 450 units, Santa Clara gets none. This happens regularly, up and down the Peninsula. Residents in Cupertino nearly passed a ballot measure that would have effectively prevented all new apartment construction. A separate measure, preventing developers from turning the local ghost mall into hundreds of homes with ground floor retail, actually passed. Unreal.

  Demand will fade as the wealthy and high-income flee. My general recommendation: If you’re starting down this land baron road, don’t do it in places like California unless you have super political clout.

  A Pothole in the Road

  I fled. The state is just too big a pothole on the road to riches. Long-term prospects are poor—i
t won’t be a future vibrant economy. The state’s spending dependency seems intended specifically to drive top earners and businesses (and, therefore, primary providers of tax revenue) away. Not only does California have the highest marginal state income tax of any state and among the very highest sales taxes—7.5 percent (with cities and counties adding surcharges on top)—it also has the most job-hostile regulations. In starting out, avoid places like this if you can. Give Washington a try, instead. I moved there and couldn’t be happier (unless it had redwood trees, the only thing missing). It’s cheap, clean, with far fewer silly restrictions. Most of my firm is now up here, and employees’ living standards are miles better than what my California folks face. I hope more of them see the light and join me up here, but for some, leaving the Bay Area is too much of a trade-off for now.

  Go to a state friendly to economic prosperity (i.e., states with no or low state income tax).

  Tireless Taxers

  Ironically, California knows it’s in trouble. The state chases down folks who flee! If you’re a big taxpayer and leave, California usually follows, audits, and often keeps sending you tax bills—long after you left! In the state’s view, if you left to avoid owing taxes, then you still owe them. State law was intentionally created to make it tough to flee. Successfully doing so involves mastering myriad minor details. If you’re considering fleeing any state’s taxes to land baron elsewhere, bone up on the rules. Engage a top tax lawyer.