In my past columns, we have been discussing my multi-pronged real estate acquisition matrix. The next element in the matrix is obtaining favorable terms. This is one of the main elements in real estate acquisitions were you have the ability, through negotiations, to cut major risks.
Land investments bought for cash normally do not produce major returns. If a property doubles in value in just three years, which means you made a good selection, if you paid cash for it, after deducting commissions, closing costs, property taxes, etc., you will be lucky to make 20 percent per year on your money, before the impact of taxes and inflation. If it takes a couple of year longer, this investment’s return is no longer as attractive.
Fully leveraging any type of investments is not wise for several reasons. For example, in income-producing real estate, the prime purpose of an investment is to produce net cash flow. Major appreciation is normally a distant factor. If you fully leverage income-producing real estate, you severely eat into to the primary reason you bought it.
However, with land, appreciation is all you are looking for, and income or net cash flow is non-existent. The way to maximize yield on an appreciating investment is full leverage – 100 percent if possible. The less money you take out of your pocket to control an investment tract, the more profit you will make when it appreciates.
However, everyone knows if you fully leverage your investments you greatly increase your risks – right? In other words, leverage is a double-edged sword. If the investment grows, you make multiples of its true growth. However, if it fails, you lose multiples of what you put up in cash. Leveraging all of your investments can bankrupt any investor if everything turns sour all at once; or can it?
Is the risk of leverage failure of the investment or loss of value? The answer is No!
The real risk of leverage is the debt instrument you sign; it’s the promissory note that collateralizes not only the investment itself, but all of your other assets if that investment fails. The language in the loan document you sign is what creates the risk. If your investment fails, this document can create a type of triple collateralization, which encompasses all of your other assets.
What would happen if you could negotiate away this total financial liability language and remove all references to the collateralization of your other assets and/or future incomes? In other words, let the only collateral on the loan be the investment asset itself for which you are borrowing the money in the first place. What I am saying is that you take no personal liability.
How do you get a bank to let you borrow on land with no personal liability? You can’t. Today, they are all federally regulated and have personal liability language built in their notes.
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As you can see, the problem with leverage is definitely the liability language in the note, not the possibility of a project failure. So what is the solution? Do not leverage any land investment at your bank or any other regulated financial institutions for that matter. No matter how well you structured your investment; no matter how perfect your research your project; no matter what other major players are in your immediate area; something could go wrong that you did not expect. One mistake can start a whole domino process and wipe out all of your other investments.
Therefore, the real question becomes, where can you finance your land investments without using a bank? The land investment industry is one of the only industries with the capability of self-financing without institutionally regulated funds.
In many markets, many owners of undeveloped land are willing to finance their own property sales, since bank financing of it is so difficult to obtain. Since these individuals are not federal or state regulated institutions, the terms and the language in these loan instruments becomes negotiable. In other words, you can negotiate no personal liability language with the investment standing as the only collateral.
Using this method can create fully leveraged investments with the same risk of cash investments. In other words, with no personal liability, you still receive all the benefits of leverage; with none of the associated risks.
The next element in my matrix is directly contradictory to many land investment products being marketed today. I do not like to buy a property that is not zoned and has no utilities currently available. Many syndicators sell the concept of buying land cheap and waiting for utilities and taking the property through the zoning process.
While this does increase returns, it also can greatly increase risk. Nothing is more unpredictable than a planning and zoning committee or a city council. I have seen some of the industry giants spend tens of thousands of dollars and without getting anything close to the zoning they needed to make a project work.
To me, buying unzoned land is a big “if.” “If” I succeed, I create a major increase in value, but “if” I fail, I may have actually paid more for the land in anticipation of success that will ever be worth it. Many cities today, across the United States are afraid of an over built marketplace scenario and as a result, are acting out their concerns by randomly denying zoning to reduce the demand on them to provide new infrastructure. This leave too big an “if” for me to feel comfortable. In addition, if utilities are not available to this property, then all of the land is good for is farming; no utilities and no zoning equals no current use.
One of the final elements in the matrix is to evaluate to whom you plan to sell your property and negotiate your acquisition to conform to their needs. This means putting on the shoes of your prospective purchaser and thinking like them. What size tract will they use? What will the market support? Are there any underlying title problems that will prevent them from wanting the property? Is the immediate market area already over built in this zoning classification? If you read your buyer’s needs well, you will greatly enhance your ability to sell at the maximum profit in the shortest time.
In my next series of columns, we will discuss economic cycles, and I will share with you a system I developed that will show you how to accurately predict Booms & Busts. This way you will learn how to know when to get out of the market before the next real estate recession begins.