Navigating Construction Contracts

Pricing structures, change orders, and mechanic liens

Last week we discussed the critical role of contractors. I also reiterated the process of adding value to your real estate investment by taking the time to: 

1. Understand your goals.

2. Focus (aka think).

3. Talk with experts.

4. Get a budget. 

5. Develop a game plan.

I wrote about the importance of talking with experts and budgeting.

This week is about navigating the process of executing a binding document with a contractor to do the work. 

It builds on the contract fundamentals I discussed in Vendor Service Contracts: What You Need To Know. Today we will expand our scope from a service contract to the specifics of construction contracts.

With the exception of the initial purchase of your investment property, construction will be where you spend the most amount of money at a single point in time. Understanding the components that make up contracts and where the risks are is critical.

Today we will cover:

1. Contract fundamentals.

2. Specific components of construction contracts.

3. The four types of pricing structures.

4. Being clear on the scope of work & navigating change orders.

5. Understanding mechanic liens and retainers.

6. Best practices.

As always, we will walk through the jargon of commercial real estate to understand the fundamentals and empower you with knowledge.

Let’s dig in.

Contract Fundamentals

The newsletter on vendor service contracts is a useful reference for some of the core components that will go into a construction contract. These components include:

• Owners - both property owner (i.e. you or your entity) and vendor / contractors.

• Scope of work.

• Whether there is a warranty.

• Cost and payment timing.

• Duration, frequency, and termination.

• Insurance.

Construction contracts build off of these components.

Specific Components of Construction Contracts

All the components above will exist in a construction contract with some caveats:

• Cost: there are four alternative types of pricing structures to define the cost.

• Scope of Work: this is critical to define clearly and include in the contract. 

• Payment Timing: how payments are managed is more nuanced. This process includes risks and leverage. 

Let’s break down these additional components in the following sections.

The Four Types of Pricing Structures

The construction industry has evolved to have four fundamental pricing structures that each have pros and cons. Different circumstances lend themselves to individual pricing structures. The pricing structures are: 

1. Time and materials.

2. Lump sum (aka stipulated sum).

3. Cost plus.

4. Guaranteed maximum (aka GMAX).

Let’s break down each one.

Time and Materials

• Best For: small jobs with a single contractor (no subcontractors).

• Pricing structure: based on number of hours at an hourly rate plus the cost of materials.

• Example: electrician at $120 per hour for 6 hours = $720 in time plus $480 in materials = $1,200.

• Pros: minimal paperwork to get contractor started. Sometimes you don’t even use a contract. The contractor just bills you for the work. Fast and efficient.

• Cons: pricing uncertainty until the job is done.

Lump Sum (aka Stipulated Sum)

• Best For: jobs where the scope of work can be clearly defined in advance and the cost is more than $5,000 or so.

• Pricing structure: fixed fee for a defined scope of work. The contractor has taken the time to understand the scope of work and given you a fixed fee to complete this work. Sometimes they give you a breakdown of the costs by line item including their general conditions and profit (see role of contractors). Other times they just give you a single amount with no backup. Either way, they are saying they will do the work for that price.

• Example: general contractor will clean up the interior of the suite / unit including paint, carpet, lighting, plumbing fixtures, and electrical improvements for a fixed price.

• Pros: clarity in the scope and costs.

• Cons: takes more time as the contractor needs to bid the work. This takes even more time for you as the owner when you are getting and comparing bids from multiple contractors.

Cost Plus

• Best For: custom remodels where price is less important OR the scope cannot be clearly defined up front.

• Pricing structure: whatever the general contractor pays their subcontractors PLUS agreed upon general conditions and a percent profit.

• Example: a unit renovation where the owner or their designer is actively involved in each step, figuring out the materials and scope of work in real time as the job is being completed.

• Pros: owner sees the cost impact of each decision but does not unfairly put the price increase risk on the contractor. This would be unfair because the scope has not been clearly defined. The contractor can’t accurately bid the work without a clear scope.

• Cons: price uncertainty until the job is complete.

Guaranteed Maximum (aka GMAX)

• Best For: very large jobs. 

• Pricing structure: similar to lump sum with transparent subcontractor costs BUT costs are tracked on an ongoing basis. At the end of the job any cost savings against the original contract are shared between owner and contractor at a pre-agreed upon split.

• Example: major renovation (or even new construction) where the pricing is in the millions.

• Pros: owner has a cap on their costs with the ability to see some cost savings.

• Cons: only appropriate for very large jobs. You are unlikely to use this as a new or smaller real estate investor.

As I said earlier, the characteristics of the work will lend themselves to a specific pricing structure. You will likely use time and materials or lump sum 90%+ of the time. 

Many contractors have their own contract forms or use the AIA templates. This is fine. Just read the contract before you sign it to understand what you are agreeing to.

Regardless of which pricing and cost structure you choose to proceed with, you will still have the risk of change orders. This is where we will focus next.

Being Clear on the Scope of Work & Navigating Change Orders

What is a change order? Have you heard of one? Does it make you squirm?

A change order is your contractor asking for more money to complete the work than already agreed to in the contract. [Note: this is not applicable for a cost plus structure. A cost plus contract is set up so everything is a change order because you are figuring out the scope as you go.]

A change order is a 1-3+ page addendum to your construction contract that adjusts the scope and cost. It must be signed by both the owner and contractor.

Change orders occur when (a) the owner changes the scope of work or (b) the contractor finds an “unforeseen condition”. Let’s give an example of each.

Example 1: Owner Changes the Scope of Work

At the start of the job the scope has been defined, the contract has been signed, and the work has started. You (the owner) see the work as it is being installed and you are having second thoughts. Maybe you don’t like the paint color or the broker gives you new information on something at a competitive building that is being well received by tenants.

You decide you want to make a change.

The contractor may be able to make the change without disrupting the timeline, but they will charge you for it. 

This is fair and appropriate. A change order will be created.

Now let’s discuss the second example.

Example 2: Contractor Finds an Unforeseen Condition

The contractor is proceeding with the work and comes upon something unexpected. Maybe the wood framing is rotted out when they remove the drywall or there is a sink hole discovered under the flooring. 

The contractor would have had no way of knowing this without tearing up the unit in advance. These are legitimate change orders. These are risks you take on as a real estate investor.

That being said, not all contractor initiated change orders are that clear. Sometimes you will have contractors issue a change order for something they should have known in advance or because the work is taking longer than they thought.

These are not always legitimate and you should push back on them. Discuss them with the contractor and work together to come up with a fair solution.

The best defense against all change orders is to be clear on the scope of work. If you want the job to be on time and on budget, define the scope of work in advance and stick to it.

Let’s move on to paying your contractor. This is where you have some leverage if you have a disagreement.

Understanding Mechanic Liens and Retainers

Contractors need to get paid for the work they do. In order to protect themselves from owners not paying them, there is the lien process. 

A lien is a document filed against your property with the county when there is a payment dispute. This tells anyone looking at the title documents of your property that you have a dispute, which will affect your ability to sell or finance your property. 

Bad news. 

Avoid this.

Here’s the sequence of steps.

1. Your contractor sends you a preliminary notice saying that they are performing work on your property for a specific dollar amount. Some larger material suppliers will even follow this same process. 

2. You pay them for the work. Keep evidence of your payments. You could even consider asking for a lien release for larger jobs. Once complete, move on.

3. If you don’t pay them for the work, the contractor could decide to file a lien which will be recorded against your property. 

As long as you pay the contractor, all will be fine. For larger jobs there is the risk that the contractor doesn’t pay one of their subcontractors and the subcontractor files a lien. This is unusual, but does happen. Just keep careful record of your payments.

The flip side of this process is that not paying your contractor can be an effective tool for the owner. Just be careful and reasonable with this.

Large jobs with multiple payments made over time have a built in mechanism for this: the retainer.

A retainer is an amount that is not paid to the contractor. Example: 10% of each bill. It really only comes into play when the job is long enough in duration that there are monthly payments. You are unlikely to see this much if at all, but the concept is useful to discuss.

As soon as you pay your contractor for 100% of the work, you lose any leverage you had. 

Why is this relevant?

Let’s say the job is 95% complete. Everything is done except for the final light fixture installations. The contractor tells you the work is basically done and the light fixtures will be installed in 2 weeks when they arrive. They ask for full payment.

Don’t pay them yet. 

Pay them an amount equal to the percent of work complete. 

You want to hold back some money until the work is 100% complete so you can keep some leverage. Contractors are busy. Once you pay them 100%, their natural inclination is to focus on the next job.

But…a contractor’s profit is often tied to the last dollars of payment. Be fair, but don’t give up this leverage to make sure the job is completed in a timely manner.

Now it is time to wrap all of this up in some best practices.

Best Practices

Construction is risky, whether it is a renovation of an existing property or building a new one. It often involves multiple trades and work on parts of the building you can’t see until you open up walls, floors, or ceilings.

This is the risk of being a real estate investor.

Here are some best practices to reduce your risk.

1. Define scope clearly in advance of bid(s). The only thing more important than having a clearly defined scope of work included in the contract is picking a contractor you trust.

2. Pay attention to payments. Track the cost and invoices in excel. Check that the amount you are being asked to pay (a) ties to the amount in the contract and (b) reflects the scope of work that is complete. Visit the property to verify this or have the contractor send you pictures.

3. Having pictures and notes sent from the contractor to you each week is an excellent protocol, especially when you are not able to get out to the property regularly.

4. Be clear on start date and duration. You want this in the contract. I once agreed to the scope and cost of a roof repair in the summer, signed the contract in September, but the contractor didn’t start the work until November at the start of the rainy season. It was a nightmare! Put the target start date and duration in the contract.

5. Manage the punch list. A punch list is a list of items that need to be fixed once the work is substantially complete. It could include paint touch up, missing electric outlet covers, or other small items that the contractor needs to fix at the end of the job. Walk the job with the contractor when the job is complete to agree upon the punch list items. Don’t pay them 100% until the punch list is complete.

6. Warranty documentation. If there is a warranty, make sure you get the documentation of this warranty from the contractor.

7. Watch out for liens. Keep records of your payments and the invoices. Consider asking your contractor for a lien waiver for larger jobs.

8. Make sure you get the contractor’s proof of insurance.

9. Work with a contractor you trust. This is the most important thing you can do. Things happen. Work with someone you trust so you can fairly navigate issues as they come up.

As always, keep learning. Increase your knowledge. Ask good questions and treat others fairly.

You got this.

Understanding the Critical Role of Contractors

How to know enough to not feel like an imposter

Last week I shared the many ways you can add value to your real estate investment: asset class by asset class.

Today I will discuss the critical role contractors play in helping you understand costs, refine your business plan, and execute your value add initiatives.

Contractors are the key player in bridging the gap between what you think you might want to do and what you can afford to do.

Have a vision of an amazing new porch on your 6-unit apartment or a new facade on your industrial building? It is all just a concept until you have a realistic sense of costs. 

Contractors give you these costs.

Today we will get into the details. You don’t even need to know what a “contractor” is. I will explain it all including:

1. General contractors vs contractors vs subcontractors.

2. The role of a general contractor and how they make money.

3. How to find a contractor and the key questions to ask them.

4. How to go from an idea to a price estimate to a real bid.

5. Signing a contract and navigating change orders.

6. Best practices.

By the end of this newsletter you will know enough to work with a contractor without feeling like an imposter.

Let’s dig in.

General Contractors vs. Contractors vs. Subcontractors

These terms are used casually and often incorrectly. Let’s get them straight.

General Contractor (GC)

A general contractor is in the business of managing construction work across multiple disciplines. Disciplines refer to things like painting, asphalt, electrical, plumbing, etc.

The key word is “general”. They are generalists as opposed to specialists.

They typically don’t have a huge team that does all of the work across disciplines. It is more likely that they subcontract out some or all of the work to others.

Subcontractors

A subcontractor is someone who specializes in a specific discipline such as painting, electrical, or asphalt. 

Sometimes they are hired by a general contractor. Sometimes they are hired directly by an owner. 

They are specialists in one or more discipline. They are the ones who will actually do the work.

Contractors

The word “contractor” is used as a general term to refer to someone an owner is hiring to do construction work. For example: “We need to find a contractor who will help us with our value add plan.”

It could either refer to a general contractor or a subcontractor.

If you (as owner) hire a “subcontractor” to paint your building, you would likely refer to them as a contractor. They only really become a subcontractor when hired by a general contractor.

Now let’s discuss how a general contractor makes money.

The Role of a General Contractor and How They Make Money

Let’s use an extreme, but not that unusual example, to explain how a general contractor (aka GC) makes money. In this case the GC doesn’t do any of the work. They have a very small team and hire subcontractors to do all of the construction work.

They will typically add one or two line items to the cost reflecting money that is going to them as opposed to the subcontractors.

• General Conditions or Overhead and Supervision: this reflects some allocation of their team that will oversee the work on a day-to-day basis.

• Profit or Fee: this is the profit they will make on the job.

Combined these two line items will reflect a 15% to 20% increase over what the GC is paying the subcontractors. Example: if you have a $30,000 job, expect to pay an additional $4,500 to $6,000 if you hire a GC. [Pro tip: if you have a much bigger job - example $500,000 - you will likely be able to negotiate a lower percentage.]

So what to you get for this additional cost? Two key things:

1. Subcontractor Relationships: GCs work with lots of subcontractors. They know the good ones and the bad ones. They can put pressure on one when needed as they may be giving them work in the future. As an owner with one property, you don’t have the same leverage.

2. Project Management: the GC will manage the day-to-day project. This includes obtaining and evaluating bids, creating subcontracts, and managing the work. The painter doesn’t show up? The GC will deal with it. Timing and coordination issues? The GC will deal with it.

Many owners think the GC earns their fee. Others want to manage the subcontractors themselves. 

My perspective: when there are multiple disciplines (aka trades) required such a painting, asphalt, electrical, drywall, and plumbing, I prefer the GC route. When it is only one discipline (ex. painting), I am more likely to go direct to a painter.

Your property, your choice.

Whichever route you take, there are some key questions to ask a potential contractor.

How To Find a Contractor and The Key Questions To Ask Them

Let’s say you have your first property and some value add ideas as discussed in last week’s newsletter: The Many Ways You Can Add Value to Your Real Estate Investment. 

Ask your broker and/or property manager which contractors they have worked with and who they would recommend. Then pick one or two to talk with to ask them the following key questions.

1. How long have you been in business? You want at least five years. Longer is generally better as it shows they run a fair and profitable business.

2. Are you licensed and insured? It is risky working with a contractor who is not. You could also consider asking for references to speak with.

3. Is this type of work typical for you? “This type of work” refers to your specific scope of work for your property. You want a contractor who is comfortable with both the scope and size (aka cost) of your job. Don't work with a contractor who only does $500,000+ jobs if you have a $30,000 job.

4. Do you have in-house design capabilities? Maybe you want to do an exterior renovation that includes painting, wood, and metal work. Many contractors have in-house design teams that can come up with a plan so you don’t have to hire a separate architect or designer.

5. What components of my scope will require a permit and what is the permitting process? Not all work (ex. painting) requires a permit. Some permitting is fast. Some is slow. Some triggers other upgrades. You want to understand this.

6. How soon could you get started and what would be your estimated timeline for the work? You don’t want to spend a bunch of time with a group only to learn that they can’t get started for 6 months.

7. What is your level of interest in working together? You want someone who wants to work with you.

You can see by this list that there is more to selecting a contractor than only costs.

But costs are important so let’s transition to pricing.

How To Go From an Idea To a Price Estimate To a Real Bid

As I described in the last newsletter, there are multiple steps in going from ideas to pricing, most notably understanding what you can afford. The steps are:

1. Understand your goals.

2. Focus (aka think).

3. Talk with experts.

4. Budgeting. This is where we will focus now.

5. Develop a game plan.

There are two main stages of budgeting and understanding how much something will cost.

Stage 1: Price Estimate or Rough Order of Magnitude (aka ROM)

This is when you are in the early stage. You need some general sense of how much it will cost to paint vs. redo the parking vs. renovate a kitchen. 

A contractor will help you do this, but they will be spec’ing their time to do so without a guarantee of getting the work. 

Be mindful of this dynamic and don’t abuse it. Only work with one contractor at this stage.

Stage 2: Contract Pricing

Once you have defined your scope, then you move to getting real bids that you could go to contract on with a contractor. 

Some like to get final pricing only from the same contractor that gave you the ROM pricing. Others like to get multiple bids.

Getting multiple bids is more work and guarantees you will have to tell 1-2 contractors they are not getting the work even though they put time and energy into the process.

But there is nothing like getting multiple bids. You always learn something and may find you get better pricing.

You don’t always have to pick the lowest price, but you do get a comfort level that you are not overpaying.

Signing a Contract & Navigating Change Orders

Once you have pricing you are comfortable with, you will move to signing a contract. There are multiple types of contract and ways contractors like to do them.

We will go through all the details of this next week.

Best Practices

So how do you make sense of all this? 

Here are what I believe are the best practices.

1. Interview the contractor. Don’t skip this part. You will learn a lot in the process.

2. Value their time. Don’t view getting a bid as “free”. It may not cost you anything at the time, but you don’t have unlimited “credit” to exercise contractors for bids forever without at some point paying them to do some work (i.e. giving them a job). 

3. GCs are a good fit when you have multiple disciplines. If only one, consider going directly to a subcontractor.

4. Don’t pick the cheapest option automatically. There is a saying in the contracting business: Cheap, Quality, Fast. You can only pick two. You may find the cheapest, but you may pay the price with low quality. Look at the total package.

5. The best contractors are found with experience and repeat business. If you are new, ask others for referrals. If you have a good experience with a contractor, keep using them. Build a win-win relationship over time.

It can be hard navigating your first job, but like anything you will get better with practice and repetition. 

Good luck!

The Many Ways You Can Add Value to Your Real Estate Investment

Options for industrial, retail, office, multifamily, and 1-4 unit residential

Last week we kicked off the series on executing your business plan and I discussed the general ways you can add value to your investment: cosmetic and functional improvements that lead to better leasing (and revenue) performance.

Today we are going to get into specifics by asset class.

As discussed in Asset Classes Explained, there are five main asset classes:

• Industrial

• Office

• Retail

• Multifamily aka Apartments

• 1-4 Unit Residential

There are different ways to add value to each of them. The themes are similar, but the details are different.

In today’s discussion, we will focus on improving the physical building(s) in both cosmetic and functional ways. We will go asset class by asset class.

By the end of this reading you will have a clear menu of options to choose from for yourinvestment. You won’t be an expert, but you will know enough to be dangerous.

Let’s dig in.

Industrial

Industrial is the most straightforward asset class. It is basically a warehouse building made out of concrete with a small amount of office inside. Industrial is used for manufacturing, storing, and/or distributing product. Anything you buy online goes through an industrial building, typically referred to as a warehouse.

So if it is a simple concrete box, there is nothing to do right? 

Wrong!

There are plenty of ways to add value:

• Paint & Asphalt: It is hard to find a better bang for your buck to change the look and feel of a warehouse than painting the building and doing a new slurry coating (aka painting) the asphalt. It does nothing functionally, but it drastically improves the first impression of tenants.

• Signage: Adding signs above each suite can give a better sense of identity. You could also add a monument sign on the street with slots for tenants’ names.

• Facade Enhancements: There are ways to make a building look more modern and create better suite identity by adding additional material elements to the exterior. For example: wood panels or metal awnings in sections of the building.

• Adding Parking or Re-striping Existing Parking: Industrial users often need space to store their trailers and other materials or for more parking for their employees. Sometimes you can expand or reconfigure your existing site to meet these needs.

• Warehouse Improvements: Industrial tenants want functionality. Your space will lease faster and at higher rents with increased functionality. Talk with local leasing brokers to understand the local tenant needs. Then consider improvements to lighting, smoothing the concrete floor, air circulation, power, and truck doors.

• Office Improvements: Although the office portion of a warehouse building may be a small percentage of the total square footage, it is important to make it clean and functional. Nothing fancy, but nothing too beat up. Your local leasing broker will guide you.

Let’s move on to retail.

Retail

Retail is much more complicated than industrial. It generally includes multiple buildings laid out across a site with ample parking. Example: a neighborhood shopping center anchored by a grocery store with 20 additional small suites such as restaurants, hair salons, workout studios, and various other stores. Customers are coming and going throughout the day, so traffic (and pedestrian) flow is very important.

With all these moving parts, there are many ways to add value.

• Paint & Asphalt: Same concept as industrial.

• Signage: Same concept as industrial, but WAY more important for retail. There should be a universal signage program that works for all tenants. It should look like a cohesive center. This often includes a large monument sign (10’+ tall) on the main road with major tenants listed.

• Facade Enhancements: Retail buildings often incorporate lots of interesting architectural elements using different materials and elevations. See figure 1 below for an example.

• Adding Parking or Re-striping Existing Parking: Same concept as industrial, but even more important. Few things deter retail customers from coming to your center more than not being able to find parking. Get the most parking you can.

• Suite Improvements: Most retail tenants want their suite to be a clean, functional box to work with. Retail suites tend to be fairly consistent in size and shape, so national tenants are used to working with these sizes. They will then customize their improvements inside that consistent shape. Go into a few Subway sandwich shops or postal annex stores and you will see what I mean.

• Amenities: Retail is about place making. The longer customers stay at your center, the more likely they are to buy from your tenants, and the more rent you can charge. The best retail operators figure out ways to make their centers inviting by adding things like outside seating, fountains, water features, fire pits, and other attractive amenities. They create places people want to hang out in.

Figure 1: Example of a Retail Facade

Let’s move on to office.

Office

When I refer to office, I am referring to buildings where people generally work on computers. I spent 20+ years of my career working inside office buildings. They can be a single building or an office park.

Here are some ways to add value.

• Paint & Asphalt: Same concept as industrial, but not always an option. Many times an office building is made of a stone material and the parking is in a concrete structure. In these cases, there is little to be done.

• Signage: Monument and building signage can be very valuable to tenants. Sometimes you can charge extra for these.

• Adding Parking or Re-striping Existing Parking: Parking can be very important for office tenants. Sometimes you can even charge more for covered parking (in a structure or under a carport).

• Suite Improvements: Office suites, particularly larger ones, are usually customized to the individual tenant needs. It is expensive and wasteful. Imagine if you remodeled an apartment every time a new tenant moved in. Welcome to the wonderful world of office! If you have a vacant suite, work with your leasing broker on a plan to create a clean, functional layout that will work for most tenants. 

• Amenities: Same concept as retail. Office tenants need to attract employees. Good amenities are appreciated by employees. They include workout facilities, coffee shops, attractive seating for lunch, and anything else that feels inviting.

Let’s move on to multifamily.

Multifamily

Reminder that multifamily is a fancy way of referring to apartment buildings. This could be a single 12 unit apartment building or a 10+ building community with 200+ units or a downtown tower with 300+ units. The higher the number of units, the more likely there are interesting opportunities to add value.

• Paint & Asphalt: Same concept as industrial, but apartment buildings are often made out of wood. Sometimes the wood siding needs to be replaced.

• Facade Enhancements: Same concept as retail. The more interesting and inviting you can make your apartment community look, the more likely you are to attract tenants.

• Adding Parking or Re-striping Existing Parking: Same concept as office, including the potential to charge for covered parking.

• Unit Improvements: Here’s where things get different than the other asset classes. Apartment tenants don’t have the ability to customize their space. They “get what they get”. The best multifamily operators do two things to their units that give them pricing power and reduce maintenance costs: (a) they put in the amenities that tenants want the most such as in unit washer & dryers, newer appliances, new cabinet doors, and new countertops and (b) they put durable materials in place that last longer such as luxury vinyl plank (LVP) flooring. These improvements command more rent, lease faster, and cost less to maintain when a tenant moves out.

• Amenities: Just like retail and office, multifamily is often about place making. This is where people literally call home. The best operators add amenities residents want most such as secure dog parks, workout facilities, nice pools with seating, BBQ areas, and business centers.

Now let’s see how 1-4 unit residential compares to multifamily

1-4 Unit Residential

Let’s remind ourselves why this is a separate asset class. It is driven by the way it can be financed. Lender’s will consider giving you a loan for your property based on your personal credit. For all the other asset classes, they evaluate and underwrite the propertyperformance. This personal credit evaluation can mean it is an easier entry point for investors.

All the same concepts of multifamily value add apply to 1-4 unit residential, but the smaller size will likely limit the number of amenities you can add.

Now that we have covered all the asset classes, let’s touch upon some additional items that apply to all asset classes.

All Asset Classes

Sometimes you will be faced with the decision of whether to repair or replace a building system. Repairing will be significantly cheaper but replacing will last longer. If a building system is too old or has been left without proper maintenance, replacement may be your only option. This can be true with parking lot asphalt, wood siding, and HVAC units.

There are also two potential value add options that are applicable across all asset classes.

• Convert the Use: Your property may be worth more if you convert the allowable use to a different asset class. Example: industrial to multifamily. It is not fast or easy, but can add a ton of value. You could then sell the land/building or redevelop it yourself.

• Parcelization: This is the process of dividing an existing piece of land (aka lot or parcel) into two or more legal lots so they can be sold individually. You may have a property with a lot of excess land. Divide it into a separate parcel to sell or redevelop it.

How to Bring it All Together

We have covered a lot. Asset class by asset class. Many ways to add value.

So how do you make sense of it all?

Here’s the formula: 

Understand Your Goals + Focus + Talk with Experts + Budgeting + Develop a Game Plan = Setting the Property Up for Success

1. Understand Your Goals: start here. Re-read Stop Chasing Every Deal: Why Successful Investors Pick a Niche. If you don’t know your goals, you will be lost at how to address each decision.

2. Focus (aka Think!): now is the time to focus on the list of options within your asset class. Which are most appealing to you? Drive the neighborhood your property is in and look at what your competitors are doing. Take pictures and keep notes.

3. Talk with Experts: this is the most important step where theory meets reality. Share your ideas and brainstorm with the local team (brokers and/or property managers) that will lease your building. They are the market and leasing experts. Ask them what they think of your property. Ask them to rank the list of options I gave you in order of priority and impact. Ask them what else they recommend doing. Check back on You Don’t Have to Do Everything Yourself: Building Your Real Estate Team to understand how to build the right team around you.

4. Budgeting: once you have narrowed and ranked your list of initiatives, it is time to start getting a rough sense of cost. You need a budget to work with. This is where contractors come in, which is next week’s topic.

5. Develop a Game Plan: Finally, look at all the information together and come up with a game plan. Don’t hesitate to circle back with the leasing team to re-visit the list now that you have a better sense of costs.

You may need to stagger your plan over multiple years due to construction lead times, seasonality, budget constraints, or timing of your leases. 

Be patient and realistic.

As with many things in life, it can feel overwhelming. By breaking it down into manageable parts, you can make progress.

You can do this!

Step by step.

One piece at a time.

Stay calm and carry on.

New Series Kickoff: Executing Your Business Plan

From business plan creation through completion

We are making great progress in our journey of understanding how to personally invest in real estate. We have covered four main subject areas so far:

1. Introduction to Real Estate Investing

2. Investment Fundamentals

3. The Acquisition Process

4. Owning and Managing Real Estate

See the end of this newsletter for the link to all 20+ newsletters so far.

Today we are kicking off a new series: Executing Your Business Plan. 

Whereas owning and managing real estate anchors you in the tasks with which every investor will be faced, executing your business plan leads you down a proactive approach to adding value to your investment and making you more money!

This is one of my favorite aspects of owning investment properties. The ability to take action to improve performance and make you more money.

Some like to say that most of the money is made in the buy (aka the acquisition). 

I agree to a certain extent. 

You can never change your original cost basis or location. These two factors play a huge role in how the property will perform.

But…they are not everything.

Your ability to identify and execute a business plan will play a material role in how well your property will perform over the months and years of your ownership.

In this series we will cover:

• Ways to add value to your property.

• How to create a property business plan.

• Construction.

• Leasing.

• Investor and lender constraints and opportunities.

Today we will start with an overview of ways to add value to your property.

Let’s dig in.

Definition: Adding Value

The terms “adding value” and “value add” are thrown around a lot in real estate investing. They are very similar terms that mean different things.

Adding value is the act of doing something to increase the value of your property. Usually you have to spend some money to create the value, but this is not always the case. Let’s list some examples of adding value:

• Cosmetic improvements

  • Exterior: this could be as simple as painting your property or cleaning up the landscaping. Anything that makes the property look better.

  • Interior: same concept for the inside of the property. Think paint and carpet.

• Functional improvements: 

  • Interior: we are staying inside the building, but we are improving the way the tenant can functionally use the property. Examples could include: improved lighting, an additional room, or new HVAC.

  • Exterior: same concept on the outside. Examples could include: expanded driveway or a new tenant signage program.

• Leasing: sometimes the biggest value creation will be through leasing. This could be through renewing and/or restructuring the leases with existing and/or leasing to new tenants. As we discussed in Cap Rates: The Simple Math of Real Estate Investing, much of real estate value is determined by the NOI. The biggest driver to NOI is usually the rent the tenants are paying. 

Improving the interior and/or exterior of a property usually go hand in hand with increasing the rents and driving up the property value.

These are examples of “adding value”. Let’s compare this to “value add”.

Definition: Value Add

Value add is most commonly used as an investment category signifying the amount of risk associated with a real estate investment. We discussed this in The Risk-Return Spectrum: Choosing Your Real Estate Investment Strategy. A quick summary:

Low Risk/Low Return ←――――――――――――→ High Risk/High Return

Core/Turnkey → Light Rehab → Value Add → Development

1. Core/Turnkey: low risk, low return. You buy a property that is well leased and maintained. There is minimal work to do.

2. Light Rehab: medium risk, medium return. There is some work to do, but it is mainly cosmetic (paint, carpet, clean up). If you do the work, you can increase the rent and value of the property.

3. Value Add: high risk, high return. There is a lot of work to do. The property might even be vacant. You will be repositioning it and taking on a lot of risk for superior returns. You will either find a tenant once the work is complete or sell it (fix and flip).

4. Development: highest risk, highest return. You build something from scratch.

So when someone says this is a “value add” deal, they are usually referring to the risk involved.

Comparison: Adding Value vs Value Add

Even in the lowest risk deals, there are often ways to add value. 

However, not all deals with the ability to add value are considered “value add” relative to risk/return.

Again, similar terms with different meaning. Here are examples of how each might be used:

• Value Add: “We have a big appetite for risk at our company. We focus exclusively on value add industrial deals.”

• Adding Value: “The deal has a ton of upside because there are so many ways to add value in the first few years.”

We will focus on adding value in this series.

A Menu of Options: Choose Your Own Adventure

Those of you born in the 1970s or 1980s may remember a book series called “Choose Your Own Adventure”. In it, the reader started in chapter 1 and was faced with a choice at the end of the chapter. Choose one option, go to page 22. Choose a different option, go to page 45. This continued throughout the book.

Creating and executing your property business plan requires a similar approach.

You start by assessing the opportunity and options available to you. From there, you start executing the plan and adjust as you go.

You have to adjust because (i) you continue to learn more about the property and the impacts of your plan as you go and (ii) the world and circumstances are always changing.

A Variety of Approaches

I introduced the analogy of three types of cars to give examples of types of real estate in Daily Issues You Will Face While Owning Real Estate. They were:

1. A top of the line Mercedes

2. A reliable but basic Honda

3. A car that constantly breaks down

Understanding the type of property you have at acquisition and the type of property you want it to become will guide your business plan.

For example, you may buy a property that is beat up (#3) but have a plan to turn it into a clean, functional property (#2) by executing your business plan.

Or you buy a property similar to a Honda (#2) but plan to not put a dime into it during your hold period knowing that it may get beat up over time (trending towards #3) but you will be able to maximize the near term cash flow.

Your money. Your property. Your choice.

What’s Next

Next week I will expand on the menu of options by sharing specific details of the ways to add value to each of our five main asset classes: 1-4 unit residential, multifamily, industrial, retail, and office.

This will give you a comprehensive “menu” of what can be done to add value.

You will then be able to combine this menu with the characteristics of your specific property and goals to come up with your own business plan.

Get ready to get your creative juices flowing. 

This is the fun part!

Vendor Service Contracts: What You Need To Know

A simple contract you will use over and over again

Welcome to another newsletter of Real Estate Investing Explained. 

Today’s topic will mark the end of the series on Operating & Managing Real Estate. In this series we covered the foundation of operations including:

• Series Kickoff and Glossary of Terms

• Getting Organized for Success

• Developing Your Leadership Skills

• Daily Issues You Will Face While Owning Real Estate

• Getting Meaning from Monthly Reports

• The Property Manager: On the Front Line of Your Property

• Real Estate Insurance: The Transfer of Risk

• Property Tax: The Expense That Never Goes Away

Next week we will be moving on to the series on Executing Your Business Plan where we will cover leasing, construction, and ways to add value.

But before we get there we need to cover service contracts. These are legal documents that are used to engage another company to do work at your property. It could be one-time or on a recurring basis. 

Examples include landscaping, pest control, cleaning, HVAC service, and many other services.

If you own a home, you might be used to bringing in vendors and technicians to fix something. You are unlikely to sign a contract. You simply pay them when the work is done.

With real estate investment properties, particularly commercial, a better practice is to use a service contract to document the details in advance including:

• Who is the owner.

• Scope of work. How the work will be performed and to what quality.

• Whether there is a warranty.

• Costs and payment timing.

• Duration, frequency and termination.

• Insurance required.

• Many other “legal” sections if prepared by a larger real estate company such as confidentiality, indemnities, dispute resolution, notices, limitations of liability, non-discrimination, OFAC compliance, and some others. Don’t worry about these sections for this discussion. You can understand them later if you develop a larger portfolio.

Yes, it is more cumbersome. But a little bit of paperwork up front will save you misunderstandings and problems in the future.

Today I will explain each of these and why they matter.

Let’s dig in.

Who is the Owner

Do you own the property as an individual or through a separate legal entity such as an LLC? There are pros and cons to each.

• Individual: 

  • Pros: easier to get a loan for a 1-4 unit residential property. Lower annual tax cost.

  • Cons: more risk of personal liability.

• Legal Entity Such as a LLC:

  • Pros: additional layer of legal protection.

  • Cons: annual LLC tax and separate tax return.

Whatever you choose, you need to make sure the service contract lists the “Owner” correctly. If you own a property through an LLC (ex. 123 Main Street Owner, LLC), don’t list and sign the contract under your name individually. Sign it under the LLC. In this case, the LLC is the owner.

Scope of Work, How the Work Will Be Performed and To What Quality

This describes what the vendor is going to do. It might be monthly landscaping or repairing a broken HVAC unit. 

A simple approach can be to ask the vendor for a proposal and then include the proposal as an exhibit to the service contract. The exhibit serves as the details of the scope of work. This way, everyone is clear and in agreement.

You could also consider adding language saying something like: “work shall be performed in a professional manner to industry standard quality”. It is not perfect, but it does set some basic expectations beyond what is written in the proposal.

Whether There is a Warranty

Not all work will include a warranty, but some should. 

Anything new, such as an HVAC unit, should include a warranty. You want at least one year.

The contract is where you agree what the warranty will be, what it will cover, and how long it will last. The vendor may also give you a separate warranty document once the work is complete.

Costs and Payment Timing

A clearly documented scope of work and list of costs will reduce the chances of there being disputes after the work is complete. They go hand in hand.

If the scope is not clear, the vendor may hit you with “change orders”. Change orders are a fancy way of saying that the vendor is going to charge you more than the amount in the contract for various reasons including (i) increased scope of work or (ii) unforeseen or unanticipated conditions.

Unscrupulous people may even try to hit you with a change order because they feel they aren’t charging enough or this is part of their strategy (low bid to get the work then multiple change orders).

Avoid the risk of change orders by being clear on the scope, the costs, and the timing under which you, as owner, will pay them. 

And don’t necessarily take the lowest bid if it is materially below the others. This can be an indicator of a vendor who doesn’t understand the scope.

Let’s move on.

Duration, Frequency, & Termination

This describes how long the agreement lasts and the frequency of the work. This varies depending on the type of work. Examples:

• Landscape Maintenance: this could be a one year contract where the frequency of service is bi-weekly or weekly.

• HVAC Repair: this could be a one-time service that needs to be done in 30 days, after which the contract is done.

For recurring services such as landscape maintenance, the practical approach is to have a one year contract that can be renewed at an agreed upon rate (example 3% increase) with 30 days notice.

There should also be language that either party can terminate with 30 days notice if one party is not following the agreed upon terms of the contract.

Let’s transition to insurance.

Insurance

We talked about insurance in Real Estate Insurance: The Transfer of Risk. 

Any time someone is coming to work on your property, there is the risk that (a) they could hurt themselves or someone else or (b) they could damage your property.

You want to require each vendor to have some basic types of insurance such as worker’s compensation to protect their employees and commercial general liability to protect you and your property. There are many other types of insurance that could be requested, but these are the two major ones.

Now that we have covered the components of a service contract, let’s discuss where to find one and how to use it on a day to day basis.

[Note: I am not discussing the “legal” sections referenced in the introduction as giving legal advice is not part of my scope.]

How to Get a Service Agreement Template

Now that you understand the basics of what is in a service contract, what do you do with the information? How do you get a contract?

As discussed in The Property Manager: On the Front Line of Your Property, I believe there is real benefit to hiring a property manager. 

A good property manager will have a standard service contract that they use. The great ones will be able to talk you through their form and explain it to you.

Don’t feel you need to reinvent the wheel. Review their template. If it looks good, use it or make the edits you need to make it work for you.

My Perspective

I believe in using service contracts, but I like them to be short and easy to understand. 

I am also mindful that asking a vendor to sign a form they are not familiar with slows down the process. Sometimes the vendor will even have to talk with a lawyer to confirm they are ok with this. This can really slow down the process when you are trying to get work done.

I try to be reasonable. 

If the vendor has their own form, I am willing to read it based on the information described above. If it is clear, then I am willing to sign it. Other times I might hand-write edits to the document to make something more clear or to make a small change.

I try not to get caught up in going back and forth on language in a document. I want to focus the majority of our efforts on getting work down at the property, not negotiating documents.

Some might say this is taking on more risk than I need to. Fair enough.

But remember that real estate investing is not risk-free. There are always things that could go wrong. If that scares you, real estate investing may not be for you.

Don’t be reckless. 

Be practical and reasonable.

I try to do business with vendors (and people in general) I trust. If an issue comes up outside of the contract, we work it out as two reasonable people.

Property Tax: The Expense That Never Goes Away

The ongoing expense that varies from state to state

Last week we discussed insurance in detail. Today we are getting into property taxes.

My original plan was to do them as a combined newsletter, but when I started writing about insurance I realized just how many layers of information there are.

Why was I planning to cover them in a single newsletter? Because they share multiple similarities:

• The amount of each expense is largely outside of your control.

• They are generally permanent. You could get rid of almost every other expense, but property taxes and insurance will always be with your property.

• They are specialized subjects that benefit from the owner having a certain amount of knowledge and expertise.

But…property taxes are simpler to explain than insurance. Phew!

Today we will discuss:

• Why property taxes exist and what they fund.

• How they are determined.

• Ways to reduce your property taxes.

• Owner best practices.

That’s it. Much more simple than insurance.

Let’s dig in.

Why Property Taxes Exist and What They Fund

Property taxes are revenue for the county the property is located in. 

Read that word carefully: county. Not the state.

They are the way each county (in each state in the U.S.) funds basic services such as public schools, police, and libraries. A portion of the revenue is sometimes distributed to each city within that county. [Yes, this is a U.S. centric newsletter.]

You may have seen a proposition or other measure on your local election ballot that talks about adding an additional fee to homeowners to fund XYZ. If passed, this would add to every homeowner’s property tax expense. Here’s an example of a property tax bill with propositions and measures that passed the voting ballot and were added to each homeowner’s property tax bill: 

Table 1: Example of Propositions on a Property Tax Bill (California). Each one increased the “rate”. More on this later.

To add another layer of complexity, property taxes are determined at the state level but administered, collected, and used at the county level.

Your main takeaway should be that property taxes fund your local government and services. They are never going away. All 50 states have some type of property taxes.

But wait - some of you may be thinking that certain states don’t have property taxes. This is not correct. Some states don’t have income taxes or sales tax, but every state has property taxes.

Let’s transition to how they are determined.

How Property Taxes Are Determined

As I said above, every state has property taxes. But unfortunately every state calculates them in a different way.

Here are the similarities across all states:

• County Assessor: the team at each county that determines, administers, and collects property taxes.

• Assessed Value: the value of the property and land as determined by the county assessor.

• Rate: a percentage that is applied to the assessed value to determine the property tax.

Here are the differences:

• Assessment Methodology: how the assessed value is determined (generally, but not always, via fair market value appraisal).

• Assessment Frequency: how often the assessed value is determined (every 1-4 years).

• Payment Timing: frequency and timing of payment throughout year (1-4 times per year).

• Payment Period: whether the payment is in advance or in arrears.

• Appeal Options: whether and how the property taxes can be appealed with the goal of reducing them.

So we have a basic framework (the similarities), but a unique way of implementing it within each state (the differences).

Here are some examples:

California

• Assessment Methodology: the value is determined by the most recent purchase price and then grown at 2% per year. That’s it. Super simple. That is why you hear of people that have owned their property for 30+ years and have a low property tax basis (and expense), while the person next door who recently bought their property has a much higher property tax basis (and expense).

• Assessment Frequency: July 1 every year add the 2% increase and adjust for propositions and measures.

• Rate: a little over 1%. Example: $1,000,000 x 1.132% = $11,320.00 per year.

• Payment Timing: twice per year in December and April.

• Payment Period: December covers the second half of the year (7/1 to 12/31). April covers the first half of the year (1/1 to 6/30).

• Appeal Options: through property tax consultants, who do not need to be licensed.

Texas

• Assessment Methodology: fair market value appraisal.

• Assessment Frequency: beginning of each year.

• Rate: changes each year.

• Payment Timing: January of the year after assessment.

• Payment Period: 100% in arrears.

• Appeal Options: typically through a lawyer.

These are just two examples. Each of the 50 states in the U.S. has a different approach.

Ways to Reduce Your Property Taxes

There are ways to appeal and reduce your property taxes. Why would you want to do this? To reduce your operating expense. And you may feel the assessed value is unreasonable.

If you own properties in multiple states with different rules, it may be helpful to use a property tax consultant such as Ryan.

The typical structure will be that they work on 100% contingency. They only get paid if your property taxes are reduced. Example: they might keep 10% - 30% of the reduction as their fee.

My personal opinion is that property tax consultants serve an important role in the industry as this is a specialized area of expertise that varies from state to state. These consultants can help save you money and estimate your future property taxes for properties you are purchasing.

My approach has been:

• Personal Home: I appealed this one myself because (i) I understood the California process and (ii) I live in a 100+ home community where the homes are very similar, making it easy to supply sales comparables. I had bought my home a couple years before the Great Financial Crisis of 2008. By successfully appealing my property taxes, I saved quite a bit of money each year.

• Industrial Portfolio: when I worked for a company with 100+ properties across many states, we used property tax consultants. It was too complex and labor intensive to justify using one of our internal team members.

Educate yourself by talking with a property tax consultant. If you own a small property (less than $5M), find a smaller local property tax consultant who may give you more focus than a larger, national firm.

Owner Best Practices

Here are my recommended best practices when working on property taxes for your investment property.

Due Diligence & Underwriting - Assessment Methodology

Remember, these vary from state to state. Don’t assume the seller’s property taxes will be your property taxes growing at inflation each year. 

Do the research and/or talk to a property tax consultant before you commit non-refundable money towards the purchase of the property. You need to understand how they will change during your ownership. 

Propositions & Measures - Expiration Dates

These often have an expiration date. This is especially important when you see a very large additional charge on a property tax bill. 

My former company once bought a property where the additional charges were as much as the base property tax bill. This was related to a fee that would expire two years after our acquisition. Knowing the near term expiration changed the way we thought about the deal.

Closing Statement - Payment Timing

The timing of the payment will determine how the property tax expense is prorated in the closing statement on closing day. This could be a big charge or credit. 

For example, if property taxes are paid in advance, you (as buyer) could find yourself owing the seller for their prepayment and have to pay this amount through the closing statement. 

What would this mean? You could be short on cash on the day of closing. Understand this in advance to avoid surprises.

Appeals

Be proactive. It doesn’t cost you anything to have a conversation with a property tax consultant. If there is a way to save money on your property taxes, you should consider this. 

Pro tip: there is usually a deadline by which you must file the appeal. Do the research so you don’t miss it.

Remember, property taxes vary from state to state. Take the time to understand how things work in the state you are buying the property.

As always, have a learning mindset. Be patient. Talk to experts. Take the time to understand it.

Real Estate Insurance: The Transfer of Risk

A breakdown of the different ways you can (and should) insure against risk

Today we are going to dive into the world of real estate insurance. 

I have spent a LOT of time on this subject in the 20+ years I worked full time for real estate companies. 

Insurance is a fascinating financial product that shares similarities to:

• Private equity, venture capital, and stock investing.

• Investment banking.

• Sports betting and assembling a professional sports team.

In each case someone is making a calculated and well researched investment (or bet) in hopes that they will make money.

Insurance is a financial instrument where insurance companies earn smaller guaranteed payments (premiums) while putting big dollars at risk (claims). Their goal is to make more money on the premiums than they pay out in claims over years and decades.

I will break down the basics of real estate insurance in a way you can understand and use. As a real estate investor, you will need (and likely be required to carry) insurance to protect you, your investors, your lender, and your property.

Today we will cover:

1. What insurance actually is

2. Types of real estate insurance

3. Premiums, limits, deductibles, policy term, & exclusions

4. Insurance policies

5. Insurance certificates

6. Lender insurance requirements

7. Working with an insurance broker

8. How to handle an insurance claims

9. Why you should strive to be a good customer to the insurance carriers

Let’s dig in.

What Insurance Actually Is

At its most basic level, insurance is a financial transaction: small amounts of guaranteed money for major risk protection.

For example, you own a property that would cost $200,000 to re-build if it were destroyed. You don’t have $200,000 sitting around, so you would be in a bind if the property were destroyed.

Enter the insurance company aka carrier (ex. State Farm, Liberty, Allstate, etc).

They offer to insure the property for $1,000 per year.

• You pay the $1,000 at the beginning of the one year policy.

• The insurance carrier will pay the cost to rebuild the property IF it is destroyed. Either way, they keep the money you paid them.

This same concept applies to many other types of insurance: auto, life, health.

The person buying insurance pays a small fixed amount. The insurance carrier keeps the money and only pays if there is a claim (damage, a medical procedure, etc.).

Now let’s get specific to real estate insurance.

Types of Real Estate Insurance

I am going to focus on insurance you would have as a personal real estate investor. 

[Note: if you own a real estate company (or any other company) with employees, there are many other types of “corporate” insurance you would want such as worker’s compensation, crime, etc. Talk with your insurance broker to learn more.]

There are two types of insurance you will want as a real estate investor: property and liability.

Property Insurance - Insuring Physical Objects

Property insurance covers physical objects from damage, theft, and destruction. Effectively, anything that could harm the object. In the case of real estate, “objects” are:

1. The building and anything attached to it such as HVAC and lighting.

2. Any supplies stored in the building such as light bulbs and carpeting.

3. 12-24 months of rental income you could lose while the building is being repaired if the tenants are unable to occupy the building and pay rent.

Think of property insurance as insuring against damage. How could the property be damaged? Fire, theft, hail, storm, wind, earthquake. It could be anything. 

Liability insurance is totally different.

Liability Insurance - Insuring You From Being Sued

Liability insurance covers you if you are sued. 

Let’s say your tenant or one of their customers/employees trips just in front of the entrance to the tenant’s suite. They break their arm and have medical bills. They could sue you.

If you are sued, the liability insurance coverage kicks in to defend the lawsuit and pay for damages (if any).

In summary, property insurance protects the building and rents. Liability insurance protects you if you are sued.

Pro tip: For additional liability protection beyond your standard policy, consider an umbrella policy that provides extra coverage (typically $1-5M) for a relatively low premium.

Additional Pro Tip: If you are developing a property from the ground up, property insurance will be known as “Builder’s Risk” and liability insurance will be known as “Owner’s Interest”.

So far, so good. 

Now let’s dive a level deeper.

Premiums, Limits, Deductibles, Policy Term, & Exclusions

There are five key factors that come into play with insurance:

• Premiums: how much you have to pay for insurance each year.

• Limits: the maximum amount the insurance carrier will pay if there is a claim.

• Deductibles: a small amount you pay if there is a claim (in addition to the premiums).

• Policy Term: the length of the policy (ex. 12 months).

• Exclusions: what is NOT covered.

Let’s briefly discuss each one.

Premiums

Premiums are the fees you as the person buying insurance pay. It is the insurance carrier’s revenue.

Limits

Limits are the maximum amount the insurance carrier will pay if there is a claim. Two examples:

• $200,000 property claim and the policy limit is $150,000.

  • The carrier will pay $150,000 (policy limit < claim). 

• $100,000 property claim and the policy limit is $150,000.

  • The carrier will pay $100,000 (policy limit > claim).

Pay attention to your limits to make sure they give you adequate coverage.

Deductibles

If you have ever paid attention to a health insurance claim, you are probably familiar with a deductible. It is the additional amount you have to pay (in addition to your premium) in the event there is a claim. In the $200,000 example above, the deductible might be $1,000. You would pay this as part of the claim, but you only pay it in the event that there is a claim. The concept is that you will have to cover minor costs and the insurance carrier only steps in for more “major” claims.

Policy Term

This is the length of the policy. Most policies for real estate are 12 months.

Exclusions

Certain events will not be covered under your typical property or liability policy. If you want this coverage, you will need to buy a separate (and often more expensive) policy for this specific risk. Sometimes they are included in your property policy with higher deductibles. Examples of exclusions include: (i) earthquake risk in California, Oregon, and Washington, (ii) hurricane risk in the Gulf of Mexico region, (iii) hail risk in Colorado and Texas, and (iv) environmental pollution. 

Note that “wear and tear” is almost never covered by insurance. The 20 year old HVAC unit that stops working will not be a covered claim.

Pro Tip: Look out for “vacancy exclusions”. Vacant buildings are at higher risk for theft and vandalism. Most policies exclude coverage for vandalism and theft for buildings (not suites) that have been vacant for 90+ days. Make sure you read your policy to understand this risk and consider better lighting and/or security for vacant buildings.

Let’s transition to the actual policy.

Insurance Policies

An insurance policy is the document provided by the insurance carrier. It is a legal document that outlines all the terms of the policy. 

In an ideal world you would receive a draft of the document 30 days before the start of your policy period. In the real world, these normally come 10-60 days after the policy starts.

A good insurance broker will help you negotiate the best deal points of the policy and compare the options from multiple insurance carriers.

Think of the insurance policy as adding all the specific details of the items we have discussed so far (premiums, limits, deductibles, etc.). 

The policies are long and written as legal documents. For the industrial property I own, the policy is 50+ pages. A practical approach for those of you who cringe at the idea of reading one is to focus on the following:

• Is your name and/or legal entity correct?

• Is the property address correct?

• Are the dates in the policy term correct?

• Review the premium, limits, deductibles, policy term, & exclusions.

• Review the vacancy exclusion language.

• Make sure you know who to contact if you have a claim.

Most of the time you won’t have a claim. But when you do, you don’t want to be caught discovering that you didn’t have the coverage you thought you did.

Is there an easier way to understand your policy? 

Yes. 

Enter insurance certificates.

Insurance Certificates

Whereas a policy includes all the legal language of your policy, an insurance certificate is a one page document that summarizes your policy. 

It will list the type of coverage (property, liability), limits, deductibles, policy term, and sometimes exclusions.

It is also where the insurance carrier will add “additional insured” parties as required by other documents you sign such as a property management agreement or loan agreement. 

An “additional insured” has limited coverage under your policy in the event of a claim without having to pay anything for this coverage.

This is especially true for lenders.

Lender Insurance Requirements

If you have a loan on your property, you will have a set of loan documents as discussed in Debt: An Amazing Tool with Strings Attached.

The loan documents will list various lender insurance requirements that must be met for the lender to give you the loan.

These could include:

• The types of coverage: property, liability, earthquake, etc.

• The amount of coverage: example - property insurance equal to the full replacement cost of the building.

• The maximum deductible allowed: example - $1,000 or $5,000.

Make sure you price out insurance coverage that meets the lender requirements BEFORE you sign the loan agreement.

An insurance broker can be very helpful in this process

Working With an Insurance Broker

You want to work with an insurance broker that specializes in real estate insurance.

They will help you compare insurance options to find the best combination of price and coverage. They know what is “market” and they will help you find the right fit for you.

Ask people you know who have invested in similar properties for a referral. A good insurance broker will make a world of difference.

They will also help you work your way through a claim.

How to Handle Insurance Claims

Insurance claims are a whole separate animal. They can be simple or long and tedious. 

I won’t go into much detail, but here are what I believe are the best practices having navigated claims ranging in size from $25,000 to $10,000,000+.

• Communicate early. If you think there MAY be a claim, let your insurance broker and carrier know immediately. There is no penalty or risk of an increased premium next year if there doesn’t end of being a claim.

• Ask questions. You will likely be assigned a “claims adjuster” by the insurance carrier. Ask for clarification of the process and timeline.

• Be persistent. Claims adjusters often have an unmanageable workload. Don’t be a jerk, but be persistent.

It is a process. Not a fun one, but one that can be navigated. It will help if you are already a good customer.

A note on asset classes and claims. Different asset classes tend to have different types of claims and frequency of those claims.

• Multifamily and 1-4 Unit Residential: highest claim volume from “slip and falls” and kitchen fires.

• Retail and Office: “slip and falls” are most common claims.

• Industrial: theft of copper and other “recyclable” materials are most common claims.

Go in eyes wide open as you consider your asset class and strive to be a good customer.

Why You Should Strive to Be a Good Customer to the Insurance Carriers

What does it mean to be a good customer to the insurance carrier? It means:

• You pay your premiums on time. This is their revenue.

• You maintain your property well and have good standard operating procedures. This leads to lower risks of claims.

• You are loyal. You don’t switch carriers every year. 

An insurance company will look at you (their customer) in terms of how you have performed over the life of the relationship. Remember that their goal is to make more money on the premiums than they pay out in claims over years and decades.

You are more likely to have lower premiums each year (and a better claim outcome) if you have been a customer for five years without a claim than if you are three months into your first policy year with the company. 

Don’t necessarily change carriers every year to save a few bucks. Think of it as a long term partnership.

Pro tip: as you build up a portfolio of properties, look into putting them into a single “portfolio” insurance policy. This could save you money and make things simpler to operate.

Closing Thoughts

Don’t be intimidated by insurance. Understand that it plays an important role in the world of real estate investing. 

View it with curiosity and always be learning.

The Property Manager: On the Front Line of Your Property

Why the relationship with your property manager is so important

As we did last week, let’s anchor in on where we are in the process of learning how to be a real estate investor.

• You own your first property.

• You have a business plan and are in the early stages of executing it.

• You have hired a local property manager.

• You are eyes wide open that unexpected issues will come up.

• You understand how to review the monthly reports.

Today we are going to discuss how to work effectively with your property manager.

Your property manager is on the front line of your property. They are the main point of contact with tenants and vendors. 

Your tenants’ experience of the property will be based on four things: 

1. Where the property is physically located.

2. How much rent they have to pay.

3. The physical condition of the property.

4. How the property manager responds to their requests and challenges.

You can’t change the location and you want to maximize the rent. The physical condition is generally fixed other than the ability to maintain it and possibly improve it.

It is the performance of the property manager that is the most malleable. It is one of the few things that you as the property owner have the ability to influence.

Today we will discuss:

• The role of the property manager.

• Why being a property manager is so challenging.

• When to hire a property manager and how to find a good one.

• The importance of setting clear expectations relative to your operational philosophy and goals.

• How much discretion to give the property manager.

• What to do when things aren’t working out.

Let’s dig in.

The Role of a Property Manager

A property manager is the person or team that manages the property for you on a day to day basis. They will likely be an employee of the company you hire to manage your property.

In addition to the monthly reporting package generated by their team, they have two main focus areas:

1. Tenants

2. Vendors

Tenants

Property managers respond to tenant requests and give tenants direction. They use the lease (and instructions from the owner, if any) to determine how they respond to issues. Here are some examples of issues that will come up with tenants.

• The tenant is paying rent late.

• The HVAC unit in the tenant’s suite stopped working and needs maintenance.

• The tenant is leaving trash in the common area.

The property manager has to interpret how to handle the issue, get approval from the owner, communicate the resolution to the tenant, and make sure the tenant cooperates.

This is very easy to say, but hard to do.

Vendors

Property managers also hire vendors to maintain, repair, and upgrade your property. Some of this is done proactively. Some of this is done reactively. You as the owner set the direction of the maintenance standards, but it is the property manager who has to execute this. Here are some examples of issues.

• Exterior maintenance relative to cleanliness and the landscaping.

• Preventative maintenance (if any) of the building systems.

Want to operate your property like a slum lord? It falls on the property manager to execute this and face the consequences of the unhappy tenants.

Why Being a Property Manager is So Challenging

Let me state this clearly:

The role of a property manager is one of the hardest in the real estate industry.

Why?

There are multiple reasons:

• Lack of Time Control: a property manager is faced with a variety of issues each day, many of which are unplanned and time sensitive. Things break. Emergencies happen. Property managers have a very hard time keeping control over their schedule and time.

• Workload: property management is a low margin business. Owners of property management firms tend to overload their property managers with a heavy workload.

• Context Shifting: a property manager is a jack of all trades. From communicating with a tenant, to analyzing a lease, to reviewing and commenting on a financial report, to preparing a vendor contract, to interpreting a technical building issue - a property manager has to do it all, often in a single day.

• 80/20: 80% of what happens at a property goes well and unnoticed. It is the 20% of issues that go wrong (most of the time outside of the property manager’s control), that get noticed and complained about to the property manager. It can be a thankless job.

Let me say it again.

The role of a property manager is one of the hardest in the real estate industry.

The good ones do all of this with amazing customer service and keep everyone happy.

I have SO much respect for property managers. 

When to Hire a Property Manager and How to Find a Good One

Some of you may be considering managing the property yourself. That is fine, but proceed with caution. 

I did this for a year on my property. It is like taking on a part-time job. Once I received an emergency call while on vacation with my family, I realized I would much rather pay someone else to do the work.

Hiring a property manager is particularly important if any of the following criteria apply to you:

• You don’t live near the property.

• You have a full time job.

• You have a low tolerance for customer service issues.

• You put a high value your time and mental peace.

The good news is that there are great property managers out there. Here’s how to find one.

• Ask for referrals. Search the internet. Ask AI. Note: referrals are the best.

• Interview 2-3 firms. Yes this will take time, but it will give you a good comparison.

• Check references. What are their existing clients saying.

• Request an example monthly report.

• Discuss your operating philosophy and goals.

You don’t always want to go with the cheapest option. Find the one that has the right balance of costs and service - and who is on board with your philosophy and goals.

A note of fees: property managers typically charge a fee based on percentage of rent collected from the tenants each month. This varies by market and property type. Here’s a rough range to give you an idea:

• 1-4 Unit Residential: 8-10%

• Large Multifamily, Retail, Office, and Industrial: 3-5%

They may also charge fees for construction management, leasing, and other “one time” services.

Once you select the right property manager for you, make sure you set clear expectations.

The Importance of Setting Clear Expectations Relative to YOUR Operational Philosophy and Goals

In a previous newsletter - Daily Issues You Will Face While Owning Real Estate - I discussed the importance of being clear on your own operating philosophy using three types of cars as an analogy: 

Do you want to operate the property like a top of the line Mercedes, a reliable but basic Honda, or a car that constantly breaks down?

If you don’t understand your own philosophy and goals, your unfortunate property manager will either (a) constantly be guessing at how to handle issues and coming to you regularly for direction or (b) taking action on issues that may or may not be what you want.

Take the time to be clear on your philosophy and goals.

Once you do this, you can set the framework of a good working relationship with your property manager that will benefit your property. Here are the specific steps I recommend:

1. Send an email to the property manager explaining your philosophy and goals.

2. Meet with the property manager onsite to walk the property and discuss your philosophy and goals. Make sure you take the time to get to know your property manager and understand their daily workload outside of your property. 

3. Agree upon expectations for how the property will be operated day to day. 

4. Agree upon how often you will have a call or meeting and what will be covered. This will be much more efficient than ad hoc communication.

5. Agree upon what communication should fall outside of the call/meeting schedule. What should qualify as an emergency? Do you prefer texts, calls, or emails?

6. Agree to check in after 90 days to discuss what is working and not working.

Setting the foundation up front will help establish a clear working relationship that will benefit each of you and the property.

Here are some examples of how you can operate a property to give you an idea of how to develop your own operating philosophy.

Tenant Compliance

• “Letter of the Lease”: strictly interpret the lease. Don’t give the property manager any wiggle room. If the tenant is unhappy, too bad. They signed the lease. If they paid a day after the grace period, immediately move to eviction.

• “Best of Alternatives”: use the lease as a foundation, but be practical. You may be strict on the rent, but be more flexible on maintenance issues. Maybe the lease says that the tenant has to maintain the HVAC, but you tell the property manager that you are willing to pay for maintenance issues for tenants who are consistently paying rent on time.

I like option 2, but it does run the risk of getting out of hand if not closely monitored.

Property Maintenance

• “Reliable but Basic Honda”: keep the property functioning well, but don’t try to fix and improve every possible issue.

• “Top of the Line Mercedes”: keep everything looking and functioning perfectly. Cost is irrelevant.

• “Car That Constantly Breaks Down”: do the bare minimum.

I operate my property as a “reliable but basic Honda” and use the “best of alternatives” approach to tenant issues.

Once you have set clear expectations with the property manager, you will want to decide how much discretion they should have.

How Much Discretion to Give Your Property Manager

When I talk about discretion, I am mainly referring to financial discretion. Spending money.

Your property manager will be making decisions daily that don’t cost any money. This is what you want. There is no point in paying someone to manage your property if they have to come to you for approval on every issue.

When it comes to financial issues, I recommend setting a dollar threshold under which the property manager has the discretion to resolve issues without coming to you for approval.

For example, you could set a threshold of $250. This could be per issue with a monthly cap or per month. This allows the property manager to resolve small issues without having to come to you each time for approval. It will save each of you time and will benefit tenant relations as issues can be solved real time.

Try a dollar threshold for a few months. If it works well and you develop an increasing level of trust with your property manager, consider increasing the threshold. If it is not working, consider reducing or eliminating the threshold.

Remember that you can change things over time. 

Start with an approach, set a time period under which to try and evaluate it, and then make modifications if needed.

What To Do When Things Aren’t Working Out

All that being said, you can do everything to set yourself, the property manager, and the property up for success, but still have problems.

There will be times when things aren’t working out. 

Welcome to being a real estate owner.

Here are some red flags to watch for relative to the performance of your property manager.

• Poor Property Condition: the property is not being maintained to your agreed upon standards. You see this repeatedly in your property visits.

• Non-Responsiveness: your property manager does not respond to your emails or calls. You may also hear from your tenants saying they are contacting you because the property manager is not responding to them.

• Poor Treatment of Tenants or Vendors: in short, your property manager acts like a jerk.

• Deadlines Consistently Missed: your property manager is responsive, but never hits agreed upon deadlines.

Sometimes these issues can be resolved with a conversation with your property manager (or your property manager’s boss). Sometimes they can’t.

When they can’t, it is time to make a change. Don’t settle for poor performance. You will lose tenants and spend more money maintaining your property in the long run.

Interview 2-3 new property management companies to find a better fit for you.

Closing Thoughts

Finding the right property manager is critical to your success as a real estate investor. 

In the property I own directly with a partner, I experienced three of the four red flag issues above with the first property manager. I ended up firing them and finding a new one. 

Everything has been SO much better since then. It was worth the time and the additional monthly expense.

Take the time to find the right team for you and your property.

Your time. Your money. Your choice.

Getting Meaning from Monthly Reports

Understanding income statements, rent rolls, A/R, and balance sheets

Let’s anchor in on where we are in the process of learning how to be a real estate investor.

• You own your first property.

• You have a business plan and are in the early stages of executing it.

• You have hired a local property management and accounting firm.

• You are eyes wide open that unexpected issues will come up.

Having a clear business plan relative to leasing and construction is probably the most important step you must take. We will get into the details of this in a future newsletter.

Today we are going to discuss how to interpret and get meaning from the monthly reporting package you will receive from your property management and accounting team.

I will define and discuss the individual reports that go into the reporting package:

1. Summary page

2. Rent Roll

3. Accounts Receivable (aka A/R)

4. Cash Flow and Income Statement with a Comparison to Budget

5. Balance Sheet

6. Construction Activity & Leasing Report

You do NOT need to have any accounting knowledge to understand these. All you need is patience, common sense, and a little guidance from Professor Bateman.

Let’s dig in.

Reporting Package Overview

Let’s start with the very basics.

What is a “reporting package” and where does it come from?

• What: a reporting package is a collection of reports that help you understand how your property is performing.

• When: it will likely be delivered to you within the first 10 days for the month and include activity for the previous month. Example: by May 10th you receive the report for April.

• Format: it will be a pdf sent to you by the property manager.

The property manager’s accounting team will have prepared it according to the company’s accounting practices combined with the structure you (the client) have agreed upon. [Note: if you don’t have a property manager, you might have prepared it yourself or hired an accountant to do it.]

You don’t need to be an accountant to understand the reports, but it does help to have some foundational knowledge. Here are some basics.

Whenever there is financial activity at a property, the accountant records it in the general ledger. This could include:

• Rent charged to or paid by the tenant.

• A maintenance invoice received by or paid to a vendor.

• Distributions made to investors.

• And any other financial activity.

Think of the general ledger as a big excel file with (i) a date, (ii) a category ID, (iii) the amount, and (iv) comments.

Most reports are just a roll up of this activity, summarized in a specific way using the dates, category IDs, and amounts.

That’s about it. Yes, it is an oversimplification of the reporting process but it gives you an overview of how it works.

To be clear, it is way more complicated if you are doing the work, but as a reader of reports this should anchor you on the basics.

Now let’s discuss the individual reports within the reporting package. Your specific report may be different in order and content. Use the list below as an example only.

#1 - Summary Page

The summary page is just as it sounds: a summary. It will include highlights such as:

• Property square feet and percent leased.

• List of new or vacating tenants.

• Amount of rent not paid (aka delinquent).

• List of construction or maintenance projects.

• Current cash, recent distributions, NOI and any other “snapshot” financial data.

There may be comments on some or all of these or it could just be a statement of the facts.

All of it will likely be in one page. It will help you understand the overall property performance before you read the individual reports.

#2 - Rent Roll

The rent roll is a summary of the leases and suites for your property.

Each accounting firm will create a slightly different version of a rent roll. Rent roll templates can also differ by asset class.

See below for an example of a rent roll for a three unit residential property.

Example: Rent Roll of 1-4 Unit Residential Property

It gives you a way to see your tenants in a summarized report. If there was a vacant suite, it would be listed as vacant as shown in the example below.

Example: Rent Roll of 1-4 Unit Residential Property - Including Vacant Suite

Important Note: never rely exclusively on your rent roll when making a decision about a specific tenant. In this case, you want to refer to the signed lease as there could have been a mistake made when the rent roll was prepared.

That being said, rent rolls are very useful to reference day to day.

Let’s move on to the A/R report.

#3 - Accounts Receivable (A/R)

Whereas a rent roll lists what each tenant is contractually required to pay each month, the A/R report will be your guide to what the tenant actually paid.

In the example above, Tenant 1 in suite A is supposed to pay $1,000 per month. If they did not pay that month, the A/R report would show this outstanding balance (aka delinquency).

Example: A/R Report

The comments would have been added by the property manager who would have (hopefully) contacted the tenant to find out what was going on.

It is then your decision as the property owner to decide whether to allow the tenant some time to catch up on the rent or move to eviction.

Let’s move on to the overall property performance reports.

#4 - Cash Flow & Income Statement

Rent rolls and A/R reports are specific to revenue. The cash flow and income statement capture the revenue and expense activity that combine into the net operating income (NOI) and net income.

As an individual investor, I like to think of the cash flow and income statement as a single report.

But those of you who are accountants or in the real estate industry probably recognize that this is not always the case. Here’s how they differ:

An income statement is a summary of activity through NOI and inclusive of debt service, capital improvements (capex), leasing costs (tenant improvements and commissions) that totals in net income. It does not necessarily correlate to (a) the cash activity that occurred at the property that month nor (b) include a starting and ending cash balance.

This is because there are many, many accounting rules that indicate how reports should be prepared. They are anchored on logic that makes sense, but do not always result in helpful information for an individual investor.

Here’s what a cash flow and income statement might look like.

Example: Cash Flow & Income Statement

It looks like an income statement through “Net Income” but then adds comments on the starting and ending cash to give you an ending cash balance.

Cash is king. You always want to know how much cash you have.

A further variation on the income statement would be to include a “comparison to budget”. This would look like the example above with three extra columns:

1. The budgeted amounts for that month. The monthly budget would have been finalized at the end of the previous year - in this example, the end of 2025.

2. A comparison of the actual amounts to the budgeted amounts.

3. Comments on any significant variances to budget.

Now that you have a sense of a cash flow and income statement, let’s move on to the balance sheet.

#5 - Balance Sheet

A balance sheet is a snapshot of assets, liabilities, and equity.

• Assets are things at the property that have value.

• Liabilities are things the property owes to others.

• Equity is the difference between the two.

It looks like this.

Example: Balance Sheet

The balance sheet is literal. It must “balance”.

• Assets = Liabilities + Equity

• Equity = Assets - Liabilities

Balance sheets are helpful to track your liabilities, but I don’t find them particularly useful in my day to day operations of a property.

#6 - Construction Activity & Leasing Report

These last two reports will vary in both who they come from and what they look like.

A construction activity report will likely come from the property manager. It will provide some level of detail on planned, in process, and completed construction activity. It will show things like (i) costs - both budgeted and actual, (ii) timeline - both budgeted and actual, (iii) a narrative on how the work is going.

This will likely be your most important report if you are in the middle of a renovation.

A leasing report will either come from your property manager (all residential properties) or your broker (all commercial properties). It will show leasing activity and lease comparables (aka lease comps).

Lease comps are completed leases at similar properties. They help give you a benchmark of what similar properties are leasing for in the same market. They help you determine what you should charge for rent for your property. We will get into this in a future newsletter.

So what is the takeaway on all these reports?

My Recommendations

Here’s how I use the reports.

For the deals in which I am a limited partner (LP) investor, I read the summary of the report with a focus on what is most important to me. If cash flow (aka investor distributions) is most important, I focus on that.

I recognize that as an LP (a) I have no control over day to day activity nor decision making and (b) I have invested as an LP so I don’t have to do any work. With this in mind, I don’t bother reading much beyond the summary page(s).

If you are an individual LP investor, you will “get what you get” relative to reports from the general partner (GP). Here are three examples of reports I get as an LP investor with three different GPs.

• Monthly report an income statement and balance sheet, but with minimal narrative.

• Quarterly report with detailed narrative and an income statement.

• Annual letter with a narrative only. One page. No numbers.

This does not correlate to the property performance. It is just a choice that each GP has made as to how they want to communicate with their investors. As an LP, I have no ability to change this.

When I am investing by myself or with a partner, I take the opposite approach to reviewing the reporting package.

Not only do I read everything in the report, but I also have my own excel file of (i) monthly cash flow and income statement, (ii) rent roll, and (iii) capex report.

My excel based cash flow and income statement includes both historical and projected amounts per month with a running cash balance so I can project capital spending and investor distributions.

It is more work for me to enter the information from the reporting package pdf into excel each month, but it is well worth the effort as this makes sure I really understand the property financial performance.

A side benefit is that as long as the property manager gives me the information I need to enter into my excel file, I don’t care what format they deliver the reports to me in. They can use their standard templates.

Recognize that if you ask a property manager for customized reports that differ from their standard templates, it may be more work for them. This could mean more costs to you.

Make sure you agree on the content, timing, and frequency of the reporting package before you hire your property manager or accountant. I suggest starting by requesting an example reporting package and seeing if it has the content you need.

Red Flags to Watch For

As you review the reports, here are a list of things to be on the lookout for.

• Increasing A/R: this indicates tenants are consistently paying late or not at all. Work with your property manager to come up with an action plan.

• Actual Expenses Are Significantly (>10%) Over Budget: either your budget was too low or there are issues going on at the property. Discuss with your property manager.

• Minimal Cash Balances: always leave a cash cushion for the unexpected.

• Vacant Suites Staying Vacant for 3+ Months: work with your property manager or leasing broker. You may need to lower the asking rate or change brokerage teams.

• Construction Delays and/or Cost Overruns: watch this closely and actively manage the team managing the jobs.

Pay attention and don’t be shy about calling your property manager to discuss in detail. Use your common sense and ask questions. Don’t be a jerk, but don’t be too passive.

Your Property, Your Choice

You can decide how you approach each investment.

It is your investment, your money, your time.

And you can always change your approach to report review over time. That is what I did.

How I approach it today is different than I did five years ago and will likely change five years from now.

That is learning and evolution. As my needs change, I adapt my approach to better meet my needs.

Don’t be intimidated by the jargon of real estate reports: income statements, rent rolls, and balance sheets.

Ask your property manager or accountant to explain them to you in simple terms. Take notes. Be a student.

After reading a month or two of reports, you will find they are key to extracting meaningful insight into how your investment is performing.

Daily Issues You Will Face While Owning Real Estate

From A/R to maintenance issues to finding tenants

Over the past three weeks we have covered real estate terms, getting organized, and developing your leadership skills.

Now we are going to get into the day to day issues you will face as a real estate investor. 

Just as we did in the discussion on due diligence, we are going to use an income statement as our guide. 

• Revenue

• Operating Expenses

• Capital Improvements

• Leasing Costs

• Interest Costs (i.e. debt)

• Other Issues Affecting Value

Almost everything you will be faced with could have an impact on the income statement. All other issues will have an impact on sale value and debt options.

I won’t overwhelm you with trying to give every detail of each issue. Think of this as a high level overview. We will dive into the specifics in the rest of the newsletters in this series on operating real estate.

Let’s dig in.

What is an “Issue”?

For this discussion, let’s define an issue as something that comes up that you have the power to take action on. That is not to say that there is a solution for everything, but most of the time there is something you can do.

But let’s make something very clear: 

There are many things that will be outside of your control that will affect the performance of your property. Examples of these over the past 10 years include:

• A global pandemic

• Inflation that impacts both costs and interest rates

• War

• Political policies and changes in laws

That being said, there are many things within your control. You want to know what those are and what your options are. That is where this newsletter comes in.

Let’s start with revenue.

Revenue

As a reminder, revenue is made up of rent from tenants (and other income like parking) but is offset by vacancy and credit loss (i.e. tenants not paying rent).

Issue #1 - Tenants Not Paying Rent

You have leases in place but the tenants are not paying rent or are paying late.

• Your Options: (i) do nothing; maybe you can live with the tenant paying late as long as they pay by the end of the month, (ii) same as previous but also charge a late fee, (iii) talk with the tenant to understand if this is a temporary issue; if so, work out a payment plan, or (iv) evict the tenant.

• Future Discussion Newsletter: property management.

Issue #2 - Existing Tenants Causing Problems

Maybe they are loud or leaving trash in the common areas. They are doing something that disrupts others and/or damages the property.

• Your Options: (i) do nothing; be a passive landlord, (ii) all bark, no bite - threaten to do something but never do it, or (iii) give the tenant a deadline to resolve the issue and then move to eviction if they don’t.

• Future Discussion Newsletter: property management.

Issue #3 - No Tenant

To state the obvious, if you don’t have a tenant in one of your units you will not get rent. Said another way, this is vacancy at your property. It is like an airplane that takes off without a passenger in a seat. You will never get that rent back.

• Your Options: (i) find a tenant by working with a motivated broker that knows the local market and/or (ii) expand an existing tenant.

• Future Discussion Newsletter: leasing.

Issue #4 - Lease Rate

How aggressive do you want to be in setting your lease rates? Are you willing to give an existing tenant a lower lease rate than you would a new tenant?

• Your Options: understand the market conditions and decide on an operational philosophy. Maybe you care more about steady cash flow than driving the rent as high as possible with periods of vacancy.

• Future Discussion Newsletter: leasing.

Issue #5 - How a New Tenant Will Use the Space (Commercial Properties Only)

You may have a tenant ready to lease your space at a great lease rate, but you are concerned about how they will use the space. You could be worried they will be disruptive to other tenants and/or be hard on your property. 

• Your Options: talk with your broker and people your trust. Check with your insurance broker to see if it will affect your insurance rates. Consider a shorter term lease and put strong usage language in the lease.

• Future Discussion Newsletter: leasing.

That should be enough to chew on for revenue. Let’s move on to operating expenses.

Operating Expenses

Operating expenses are made up of utilities, repairs and maintenance (“R&M”), insurance, property taxes, and property management fees (“PM Fee”). Some assets will have a more detailed list, but these are the major items.

Issue #6 - R&M: Costs vs. Quality

You will have a number of vendors performing services such as landscaping, pest control, HVAC maintenance, etc. You will need to analyze the trade-offs between frequency, quality, and price.

• Your Options: develop your own operating philosophy. What kind of landlord do you want to be? Do you want to operate the property like a top of the line Mercedes, a reliable but basic Honda, or a car that constantly breaks down?

• Future Discussion Newsletter: property management.

Issue #7 - Property Manager

This is a similar concept. What are you looking for in your property manager? How proactive do you want them to be? Are you willing to pay more for a property manager with a manageable workload, or do you want the cheapest that has an unrealistic number of other properties?

• Your Options: same concept as R&M costs. 

• Future Discussion Newsletter: property management.

Issue #8 - Insurance

Insurance can get expensive. You will be faced with the choice of having broad coverage or minimal coverage. If you have a loan on the property, the lender will play an active role in determining your coverage requirements. Broad coverage is more expensive than minimal coverage and unfortunately there is no “right” answer to the amount of coverage to have. Additionally, you may have to file an insurance claim at some point.

• Your Options: (i) understand your tolerance for risk and (ii) dive in deep and early when you have an insurance claim by actively engaging with your insurance broker and/or claims adjuster.

• Future Discussion Newsletter: insurance and property taxes.

Let’s move on to the “below the NOI” line items. Reminder: NOI = Revenue minus Operating Expenses.

Capital Improvements (aka Capex)

Issue #9 - Repair or Replace

Things are going to break and deteriorate. That is the reality of owning a property. It might be the HVAC unit, a dishwasher, or a section of the roof. As the landlord, you may need to address this under the terms of the lease.

• Your Options: (i) read the lease to determine who is responsible for the issue - landlord or tenant, (ii) review the age of the system - example: if the HVAC unit is 20+ years old, a replacement may make more sense than a repair, (iii) price out both the repair and the replacement, and (iv) get opinions from multiple vendors.

• Future Discussion Newsletter: construction.

Issue #10 - Replacement Quality

This is the same concept as R&M vendors and property managers. How high a quality system and work do you want for your property. Are you OK with the cheapest lighting, HVAC, and quality of work that won’t last as long but is less expensive? Or are you willing to pay more for high quality systems and work that will last longer term?

• Your Options: (i) develop your own operating philosophy, (ii) be eyes wide open on the trade-offs and the reality of your cash position, and (iii) get multiple bids for the work and talk with the contractors about their work before you sign a contract.

• Future Discussion Newsletter: construction.

Leasing Costs: Tenant Improvements (“TI’s”) and Broker Commissions

Issue #11 - Your TI Budget

How much are you willing to spend for the right tenant? What is the reality of your cash situation? Although TI’s are mainly applicable to commercial properties, the same concept applies to residential relative to how much you want to improve the unit for a prospective tenant.

• Your Options: (i) develop your own operating philosophy, (ii) be careful of tenants that want specialized TI’s that are unlikely to be re-used by a future tenant, or (iii) try to push the cost of the TI’s onto the tenant in exchange for free rent and/or a lower lease rate.

• Future Discussion Newsletter: leasing.

Issue #12 - Leasing Commissions (Commercial Properties)

Brokers play a very active role in leasing commercial properties. Commissions can get expensive and need to be paid at the time the lease is signed (i.e. upfront). This can squeeze you on cash at a time your revenue is down because you have a vacant suite.

• Your Options: (i) build up cash prior to a potential vacancy and (ii) understand the time commitment and risks of not using a broker.

• Future Discussion Newsletter: leasing.

Let’s move on to debt.

Interest Costs, Debt, and Other Lender Issues

Issue #13 - Rising Interest Costs

You may be tempted by the low interest rate that come with a floating rate, adjustable loan. But if interests rates go up, your monthly interest costs could double. Yikes!

• Your Options: there may not be any options if your interest costs go up. This could wipe out your cash flow and/or put you in a situation where you can’t make debt service. Be very careful of floating rate debt. This adds a significant amount of uncontrollable risk.

• Future Discussion Newsletter: investor and lender issues.

Issue #14 - Lender Approvals

As discussed in Debt: An Amazing Tool with Strings Attached, your lender may have approval rights on a number of issues and not allow you to do what you believe is best for the property.

• Your Options: (i) read and understand the loan documents so you know your rights, (ii) develop a positive working relationship with your lender from day one and be reasonable; this will pay dividends in the future, and (iii) make the case for why you want to do what you want to do.

• Future Discussion Newsletter: investor and lender issues.

And finally, let’s quickly address “other issues”.

Other Issues Affecting Value

There are some issues that may not affect your cash flow during ownership, but will be problems when you go to sell or refinance the property. These could include:

• Environmental issues

• Zoning changes

• Challenging neighbors

• Challenging tenants

Your Options: (i) conduct annual property reviews to identify issues early, (ii) maintain good relationships with city officials and neighbors, (iii) address problems immediately rather than letting them compound, and (iv) document everything in case issues arise during sale.

The key is to be eyes wide open on the risk to your future sale and/or refinance and then try to resolve the issues as best as you can before you are in the time crunch of a sale or refinance.

That’s the list of 15 or so issues. Are these all the possible issues you will face?

No, but they give you a sense of the type of issues you will face.

What are our key takeaways?

Key Takeaways

Here’s what you need to keep in mind:

1. Develop your own operating philosophy. Combine this with your niche, and you will have a clear foundation on which you evaluate your decisions. Without a philosophy, you will find yourself over analyzing each decision and not having any consistent approach.

2. Issues that you need to figure out will come up. Methodically break them down into parts. Do the research. Talk to experts. And then make a decision.

3. Not all issues are equal. Cash flow problems (non-paying tenants, rising interest costs) demand immediate attention. Quality decisions (Mercedes vs Honda) can be determined over time.

4. There will be unexpected costs. Keep a cash cushion. Don’t distribute every last dollar.

Life is full of challenges. Think of all the ones you have overcome in your life just to be able to be sitting here reading this newsletter.

Operating real estate is a lot more complicated than owning stock. 

It can be time consuming and stressful. There is no sugarcoating it.

If you don’t want this in your life but you still want to be a real estate investor, there is alway the option to invest as an LP and have the GP do all the work (for a fee).

But for those of you willing to do the work, it can be financially lucrative and intellectually rewarding. 

You can do it.

Developing Your Leadership Skills

The power of reading non-fiction and creating a reading journal

Reading non-fiction has made me a better leader.

No question. No debate.

I have learned so much through the reading process, not just about other subjects, but also about myself.

Last week we talked about getting organized. Soon we will be moving on to all the things that will come with operating your property: (i) proactively executing your business plan, (ii) reacting to issues, and (iii) leading others to accomplish your goals.

You need to develop your own tools to do these well. Not just the specifics of real estate, but also the fundamental leadership skills needed for these functions in anydomain.

That is why this week we will talk about reading as a foundational practice to understand yourself and develop your leadership skills.

We will cover three topics:

1. The list of some of my favorite books that talk about key skills to develop.

2. How to remember what you read by creating your own reading journal.

3. The most important skills all leaders need.

Let’s dig in.

Why Non-Fiction

Fiction is tons of fun, but non-fiction helps me grow.

It makes me a better leader, investor, employee, and professor.

It makes me a better person.

It expands my perspective and helps me think.

Non-fiction books are also an insane bargain. For less than $20 (or free at the library) you get a comprehensive presentation of someone's deep research into a subject.

That person put 100's of hours into creating it.

An editor read many drafts to perfect the organization and main points.

All of this is then there for anyone to buy for less than $20. What a deal!

So here’s a list of books I recommend to make you a better leader, not only of your properties, but also of your life and everything else you do.

Recommended Reading List

Understanding Yourself: if you don’t understand yourself, you will limit your growth.

• Emotional Intelligence 2.0 by Travis Bradberry and Jean Greaves: probably one of the most foundational discussions of not only how to understand emotional intelligence (aka EQ), but also how to develop it. Emotional intelligence is critical to working with others.

• Mindset by Carol Dweck: one of the most influential psychology books of the last decade. Do you have a fixed or growth mindset? Read this book to understand the importance of a growth mindset and how to develop one. It may change your entire perspective on life.

• Grit by Angela Duckworth: understand the need for consistency of effort over the long run to achieve your goals.

• Quit by Annie Duke: Duke is both a university professor and former world poker champion. She discusses our bias against quitting and shows you the formula for when you should quit.

• Clear Thinking by Shane Parrish: a guidebook on how to make better decisions.

Your Career & Leadership: read to help guide your career and become a leader.

• Legacy by James Kerr: short lessons on leadership based on the legendary New Zealand national rugby team. I think I have read this four times.

• The Wisdom of Andrew Carnegie as told by Napoleon Hill: this was the precursor to Think and Grow Rich. It is an interview with Andrew Carnegie full of his principles for a successful life. These lessons from 1908 still hold true today.

• The Infinite Game by Simon Sinek: a discussion on a more grounded form of leadership that yields better results.

• Atomic Habits by James Clear: the incredibly popular book on the importance of habits and how to develop them. Over 25 million copies sold. Read it. Live it.

Money and Investing: these will help you think about investing at a more foundational level than just real estate.

• What to Make of a Life by Jim Collins: helps you understand the power of what happens when you find the things you are naturally good at.

• The Psychology of Money and The Art of Spending Money both by Morgan Housel: these books help you understand the major role that psychology plays in influencing all of our decisions about money.

• The Simple Path to Wealth by J.L. Collins: this guy is the master of helping you understand the stock market and its importance as a passive vehicle for wealth creation. He also explains what IRAs, 401Ks, and 529 plans are.

• The Algebra of Wealth by Scott Galloway: wealth = focus + (stoicism x time x diversification).

• The Five Types of Wealth by Sahid Bloom: helps you think beyond wealth as being limited only to money.

Living a Good Life: making money is a way earn your freedom, but it is a pointless exercise if you don’t live a good life.

• Transitions by William Bridges: explains the three steps we go through when making transitions in life.

• 30 Lessons for Living by Karl Pillner: based on interviews with people in their 70s, 80s, and 90s. A great way to learn from those that have “been there, done that” in the journey of life.

• The Daily Stoic by Ryan Holiday: I read this every morning. One page per day. I can’t speak highly enough about stoicism. It is the 2000+ year old philosophy that is anchored on the concept of distinguishing between what you can and cannot control. Don’t waste your time getting emotional on what you cannot control. All of Holiday’s seven+ books on stoicism are outstanding.

That’s my curated list of 15+ favorites from the 50+ non-fiction books I have read in the last five years.

Now what?

Let’s say you choose to read some or all of these books. Pick one that looks interesting. Create a dedicated 20-60 minute uninterrupted block to start reading. Keep going if it interests you. Move on to another book if it doesn’t.

Remember, I didn’t magically read all of these at once. I found one that was interesting (Atomic Habits) and kept following my curiosity.

The list I am sharing here is a manifestation of the power of compounding in action.

I have found that 10-12 books per year is my pace. I tend to go through spurts, reading three books in six weeks and then not reading anything for a month or two. Find your own rhythm but make reading a priority.

Ideally, you want to retain the key learnings from each of these books to be able to refer back to them when you feel the need. This is what we will talk about next.

Remember What You Read: Create Your Own Reading Journal

I used to mainly listen to non-fiction books via audio. I enjoyed listening while on a hike or during a car ride. It was super convenient.

The downside to this convenience was that I often forgot the lessons of the book months later.

Then I heard about the concept of a commonplace library: the idea of writing down the key points or quotes of a book in a centralized place (ex. notecards by subject or a reading journal).

This required me to restructure the way I read.

I moved to a kindle so I could highlight as I go. Highlighting is key to be able to go back and reference the important parts of the book.

I bought a Moleskin journal that is dedicated to summaries of the books I read. One to two pages of notes per book. Here are the specific steps:

1. Read the book in any format that allows you to highlight specific passages.

2. Once you finish the book, set it aside for a week or so.

3. Come back to the book with fresh eyes to go through the highlighted sections. Summarize the key concepts in your dedicated journal. I don’t bother with quotes or putting in everything I highlighted. I just want to capture the key concepts. I like being limited to 1-2 pages of notes.

I now have a journal full of knowledge that I can refer back to. It is one of my favorite possessions. These pictures will give you a better sense of it.

Note: if you absolutely have to listen on audio, consider carrying around a notebook to take notes as you go.

Image 1: My Moleskin Journal Dedicated to Reading Summaries

Image 2: The Table of Contents

Image 3: An Example of a Book Summary

Anytime I am making a big decision or think of something that I have read and want to re-visit, I turn to my reading journal.

So what have I learned about leadership through reading and becoming a leader at work?

Important Leadership Skills

1. Be Clear on What You Want: get priorities correct so as to spend time on the correct things.

2. Measure Success: figure out how to measure whether you are achieving your goals. Measure what matters. Results will follow

3. Be Driven & Humble: this is the magic combination. Recognize you can always learn from others. You don’t want to be the smartest person in the room.

4. Give credit to others. Take the blame for mistakes.

5. Embody the leadership skills you admire. People will watch what you do more than what you say.

6. Build and Rely on Your Team: don’t do everything yourself. Assemble a team of people that are good at specific areas. Trust them and give them room to do things their own way. Don’t micromanage them.

7. Respect Differences: other people’s ways may be different from your own. It is results that count, not the methods.

8. Be Prepared: for meetings and discussions. This means doing the reading and research in advance and expecting the same from others.

9. Create Focus Time: progress happens in dedicated blocks of time, not in endless meeting and emails. Set aside regular blocks of 90-120 minutes to actually think and do work.

10. Take a Walk: my best ideas come from my hikes and bikes in nature. Get out of the office to think. Walking 1:1 meetings can be great too.

11. Be Curious: ask lots of questions. Always be learning.

12. Create Relationships: the team you work with are not robots. They are people with feelings. Build up your “relationship bank” with others so that you can “draw” from it when you need to have challenging conversations. You need to establish trust before you can work through conflict.

13. Don’t Be a Jerk: this should be obvious, but some people still behave poorly. Everyone is dealing with something challenging outside (or sometimes inside) the office. Be kind. Be helpful. Give people the benefit of the doubt.

14. Leaders make decisions with or without perfect information.

Reading and Leadership

Readers are leaders.

For me, much of growth and leadership is integrating information from different areas and applying them to the situation at hand.

Reading is foundational to this.

Read. Read. And then read some more.

It will make you a better investor, leader, and person.

Getting Organized for Success

Building a foundation of property information so you can focus on adding value

You are on the path to becoming a real estate investor.

You will identity your niche, study a market, find a property, and go through the acquisition process to closing. At that point you will be a real estate investor.

Then what?

How do you set yourself up for success?

The key is to build a foundation of information based on everything your learned during the acquisition and due diligence process. Half a day of organizing information could save you 100’s of hours of searching for what you need during your ownership of the property. 

More importantly, it will help you stay on track with your business plan and make better decisions.

I have found there are four ways to organize and access your property information. I like to use all four, but everyone’s brain works differently. Develop the method that works best for you.

1. Digital folder of documents.

2. Photo library.

3. Master excel and site plan files.

4. Physical notebook of most important / current information.

I will walk you through all four so that you can (a) see an example of each approach and (b) adapt them to what works for you.

Let’s dig in.

Why Take the Time to Organize the Property Information?

As discussed in Due Diligence: Your Property Investigation Checklist, you will spend significant time creating a detailed understanding of the property. You will review the Offering Memorandum (OM), develop your own financial analysis and business plan, review various reports, and get to know the market. 

In short, you became an expert on the property at that moment of time.

Don’t let this knowledge waste away!!

Take the time to organize and summarize it in a way you can easily reference when you need it.

I highly recommend you do this within the first week of owning the property. The acquisition information will be fresh in your mind. Block out 4-6 hours on your calendar. Go somewhere without distractions. Organize everything at once.

If you already own a property without a system, it is not too late. Start now. 

Let’s get into the details of the system by starting with the documents.

Creating Your Digital Folder of Documents

Almost everything you review and receive will be digital. You may print some of the information, but it will have likely been created in digital format.

Your task is to organize it into a logical folder system that you can reference (and add to) in the multiple years you will own the property.

Here’s a property folder structure that works for me:

• 01-Business Plan: 

  • Documents: business plan, underwriting model (financial analysis/projection).

• 02-Acquisition

  • Documents: OM, due diligence reports, closing documents, title policy.

• 03-Legal Ownership

  • Documents: LLC or other legal ownership entity, grant deed.

• 04-Loan

  • Documents: loan documents as discussed in Debt: An Amazing Tool with Strings Attached. 

• 05-Equity (if you have outside investors or a partner)

  • Documents: partnership/JV agreement, investor communication.

• 06-Plans & Pics

  • Documents: site plans, floor plans, ALTA survey, pictures.

• 07-Leases

  • Documents: leases, form lease agreement (i.e. your standard lease template), lease proposals.

• 08-Marketing

  • Documents: broker listing agreement, marketing materials, marketing reports.

• 09-CapEx & R&M

  • Documents: folder for each job with proposal, contract, invoices, costs, etc.

• 10-Income Statements

  • Documents: Financial reports organized by date for ease of reference.

• 11-Property Management

  • Documents: Property management agreement, tenant correspondence.

• 12-Insurance

  • Documents: insurance policy and certificates, folder for each claim (if any), insurance broker related documents.

• 13-Property Tax

  • Documents: property tax bills organized by date, property tax appeal info (if any).

• 14-Appraisals & Sale Comps

  • Documents: all appraisals organized by date, any relevant sale comparables.

• 15-Zoning City

  • Documents: zoning report / information, parking counts, city correspondence.

You can do this in dropbox, iCloud, your c-drive…it really doesn’t matter what format you use. However, I strongly encourage you to use something that (a) is backed up to the cloud and (b) can be accessed from multiple devices including your phone. Example tools:

• Cloud storage: Dropbox, Google Drive, iCloud, OneDrive.

• Note-taking: Evernote, Notion, OneNote (for digital notebook alternative).

• Spreadsheet: Excel, Google Sheets.

• Photo organization: Google Photos, iCloud Photos.

Important note: Your property documents likely contain sensitive information (financial details, tenant data, legal agreements). Ensure your cloud storage has strong password protection and two-factor authentication.

You will be referencing and adding to documents all the time. This structure gives you a place for everything. As you buy more properties, mirror the folder structure so it is easy to navigate from property to property.

Let’s move on to pictures.

Photo Library

Photos are critical to help you make decisions from afar. Even if you live in the same city as the property, it is helpful to be able to get a visual of what you are focusing on - anywhere, anytime.

Enter your phone.

Here are the steps I recommend.

1. Take pictures from every corner of the property, both exterior and interior. 

2. Put the pictures in a dedicated photo folder on your phone.

3. If you want to go to the next level, organize and label these photos in a powerpoint or other digital file. Example: you might label one as “view from northwest corner”.

These photos will be so helpful to you as you operate the property day to day. Not only will it reinforce your property knowledge as you build the photo library, but it will also save you many avoidable trips to the property. You can use your time to focus on making good decisions.

Let’s move on to the two critical documents you should create.

Document #1: Master Excel File

Even if you are not a “numbers” person, I encourage you to create a master excel file. I like to name mine “[Property Name]-Key Info-[year].xlsx”. At the end of each year I create a new one and archive the old one.

Here’s what is in the excel file. Each bullet represents a separate sheet.

• Notebook Cover: we will get into this later.

• Cash Flow: a monthly cash flow that includes the property performance and a running cash balance so I know what distributions I can make. Here’s my update protocol:

  • Monthly: update current month information based on report prepared by the property manager.

  • Quarterly: when making investor distributions.

  • As Needed: when forecasting future capex and leasing assumptions.

• Rent Roll: list of units / suites at a property with information on square footage, tenants, rent, lease start, lease end, and many other pieces of information. I update the rent roll when a lease is signed or modified.

• Vendors: list of contact information for vendors I use for the property. Put the ones you use most regularly in your contacts on your phone.

• Property Tax: list of property tax billing details by year.

This is the file I go into the most for my property. 

Let’s move on to the second critical document.

Document #2: Site Plan

Having an aerial view of the property will be very helpful. This can be as simple as a snapshot from Google Maps (aerial view) with labels of key information. Here’s a screenshot of one I made in powerpoint. 

Image: Example Site Plan with Notes

I am not looking for perfection on this. I am looking for something that I can reference easily.

Now let’s move on to what I believe is the most critical piece: your property notebook.

Your Property Notebook

A notebook you say? Why can’t it all be digital?

You can go digital only, but I don’t recommend it.

Having spent 25+ years organizing property and other information, I believe having a single purpose notebook sets you up for success.

A “single purpose notebook” is just as it sounds. One notebook. One purpose.

In this case the “purpose” is your property. Once you own a portfolio of properties, you will probably want to expand and restructure it to include the whole portfolio but for now let’s stick with one property.

You can do this with a three-ring binder, but I really like the Circa system by Levenger. It is like a spiral bound notebook that you can have blank sheets of paper for note taking but also add print outs of digital files. The key is to have multiple divider tabs for the areas of the business you focus on regularly.

Here’s the structure I use for a property:

• Cover Page: this is the “Notebook Cover” sheet from the master excel file. It is my working page of the most important information about the property. It includes:

  • Financial Snapshot: an abbreviated cash flow that includes eight lines - revenue, operating expenses, NOI, capex, leasing costs, debt service, net income, investor distributions. I have one column for previous year and one for current year.

  • Capex: list of the major building systems with anticipated (or most recent) replacement year and comments. These could include roof, exterior painting, asphalt, and any other part of the building I am focused on.

  • Loan Info: loan amount, interest rate, loan expiration date, and any operational items the lender needs to approve (see Debt: An Amazing Tool with Strings Attached for a refresher).

  • Key Initiatives: this is the most important. What am I planning to do to add value the property? It should include what, when, and the anticipated cost.

  • Action Items: this is a blank area I handwrite in as needed. I like a pencil so I can add and erase as I get things done. Example: call broker about leasing status or get bids to replace the roof.

  • Waiting: same concept as “action items” but to keep track of what someone else said they would do for my property. Example: broker - update on tenant prospect or PM - update on electrical repair.

• Tab #1: Notes: blank pages I can take note on while talking to someone or working through an issue.

• Tab #2: Projects: key documents related to value add or other projects I am working on. For example, it might include a rendering and cost estimate of an exterior renovation.

• Tab #3: Leasing: any leasing and marketing activity. It might include the leasing brochure, market reports, and notes on potential tenants.

• Tab #4: PM: this is a separate section for the key vendor list and any ongoing issues I am working with the property management team on.

• Tab #5: Building: this is where I put the site plan and other important building information in.

Tabs 2-5 change over time depending on what I am working on. When I was replacing the roof and skylights, I had a dedicated tab for this. Once complete, I repurpose the tab.

The most important aspects of the notebook system are:

1. I have a portable system I can take with me to the property, office, home, anywhere.

2. I have one place that I take notes and reference key property information.

3. It is dynamic. The structure changes with my changing focus areas.

4. It is a visual reminder that I need to stay focused on the property. 

So what do you do with these techniques?

Making Them Your Own

The key to any organizational system is to make it your own. 

Do you like to have a folder for every item? Then make a detailed folder system.

Are you a minimalist? Then have a minimal number of folders.

Are you an iPad only person? Then create a system that leverages your iPad.

It doesn’t matter how you do it. What matters is that you use a system.

Don’t wing it by trying to remember everything.

This system works for me. In a year I will have probably modified it a bit.

Find a system that works for you and make it happen. You will be making property decisions all the time. You want the information at your fingertips.

This is why having a system is so important.

New Series Kickoff: Owning & Managing Real Estate

Starting with your complete glossary of real estate terms, from AM to WALT

We have covered a lot so far. I like to think of it as three main subject areas:

1. Introduction to Real Estate Investing

2. Investment Fundamentals

3. The Acquisition Process

Today kicks off the next series of topics: 

Owning and Managing Real Estate

We will be covering the following over the coming weeks:

• Understanding the terms (aka the jargon and acronyms)

• Getting organized for success

• Developing your leadership skills

• Day to day activities

• Reading reports

• Property management and accounting

  • Contracts 101: what’s in a vendor service agreement

• Insurance and property taxes

• Leasing

  • Contracts 101: what’s in a broker listing agreement

  • Contracts 101: what’s in a lease agreement

• Construction

  • Contracts 101: what’s in a construction agreement

• Investor and lender issues

• Ways to add value to your property

• Executing your business plan

• What to do next

My core background is in real estate operations. It is a dynamic and exciting aspect of the business, filled with both opportunities and challenges. 

I will be your step-by-step guide.

This week we will focus on understanding the terms specific to real estate. 

Think of this as your real estate glossary. 

So grab your favorite beverage. 

Sit back and relax.

Let’s dig in.

Why Are There Commercial Real Estate Specific Terms?

Those of you that have worked in various industries, or even followed a particular sport, know that each domain develops their own acronyms and jargon. This is because:

• It is often more efficient to use an acronym.

• Each domain has its own unique specifics.

Commercial real estate is no exception. 

If you work for a company, you will even find that each company has their own additional layer of terms.

Don't worry. You will figure it out. 

The key is to pay attention, be patient, and ask questions. Asking questions is not a sign of ignorance. It is a sign of being a learner. This is a good thing.

The list that follows is broken into sections. You can also find it on my downloads page. Keep it handy for future reference.

Teams & Departments

This is a list of the team that is most involved in property operations.

• AM (Asset Manager or Asset Management): the team or team member that oversees and drives theproperty business plan. Think of them as the chief operating officer for a property or collection of properties. Example usage: 'I need to run this by the AM before we commit to the capital expense.'"

• PM (Property Manager or Property Management): the team or team member that oversees the day to day operations including tenant and vendor interaction. They are in the “front line”, whereas the AM team is a step removed. Example usage: 'The PM will take lead on communicating that to the tenants.'"

• CM (Construction Manager or Construction Management): the team or team member that oversees the construction. The PM team often does some construction, but the CM team handles the bigger and/or more complicated jobs. Example usage: 'The CM should handle the roof replacement as it is a more complicated job.'"

• PA (Property Accountant or Property Accounting): the team or team member that oversees the accounting and reporting. 

• Leasing: the team or team member that oversees the leasing of the property, often working with leasing brokers. 

• Broker: the team or team member that provides 3rd party services for a commission. There are brokers that specialize in leasing, property sales, and even insurance. 

• Landlord aka Lessor: the property owner (i.e. you).

• Tenant or Lessee: the tenant.

Acquisitions

These are the terms that will come up during an acquisition of a property.

• OM (Offering Memorandum): a detailed summary of the property and forecasted financial performance prepared by the broker selling the property. Potential buyers use this to create an initial understanding of the property and its value.

• Investment Memorandum: a detailed summary of the property and forecasted financial performance prepared by the buyer of the property (i.e. you). Think of this as the OM with your updated financial projections and business plan.

• Base Case Underwriting Model: the multi-year financial projection prepared by the buyer of the property (i.e. you). 

• PSA (Purchase & Sale Agreement): we covered this in Demystifying Real Estate Purchase Agreements. It is the legal document between a property buyer and seller.

• DD (Due Diligence): we covered this in Due Diligence: Your Property Investigation Checklist. This is the investigation done by the buyer of a property before they go non-refundable with their deposit.

• Go Hard or Non-Refundable: we covered this in Due Diligence: Your Property Investigation Checklist. This is when buyer completes the due diligence, waives contingencies, and “goes hard” with their deposit.

• PCA (Property Condition Assessment): we covered this in Due Diligence: Your Property Investigation Checklist. A 3rd party summary of the physical conditionof the property. It is sometimes referred to as the “engineering report”.

• Phase I or ESA (Environmental Site Assessment): we covered this in Due Diligence: Your Property Investigation Checklist. A 3rd party summary of the environmentalcondition of the property.

• Survey or ALTA Survey: we covered this in Due Diligence: Your Property Investigation Checklist. A 3rd party summary of the title conditions of the property.

Reporting

The reports will be your guide to how the property is performing. 

• Rent Roll: the list of units / suites at a property with information on square footage, tenants, rent, lease start, lease end, and many other pieces of information. Each company has their own version of the rent roll.

• % Leased:leased square feet divided by total square feet. Example: “the property is 95% leased”. 

• % Occupied:occupied square feet divided by total square feet. Example: “the property is 95% leased, but only 90% occupied because one of the tenants moved out before their lease expired”. 

• WALT (weighted average lease term): Average lease term based on lease length weighted by tenant square feet. Bigger tenants have more impact on the WALT than smaller tenants.

• Rollover Retention Ratio: percentage of tenants (by square feet leased) whose lease expired and renewed. This is expressed for a specific time (ex. one year) and calculated based on square footage. Example: “the rollover retention ratio is 65% for the last year”. 

• % Above (or Below) Market: comparison of rent for in place leases vs. market rent. Example: “market rents have gone up so much that in place rents are now 30% below market”. 

• A/R (Accounts Receivable): we introduced this in Due Diligence: Your Property Investigation Checklist. This shows which tenants have underpaid (or overpaid) their rent and other charges.

• Tenant Ledger: we introduced this in Due Diligence: Your Property Investigation Checklist. This shows all the charges and payments associated with each tenant. The A/R report is a moment in time. The tenant ledger is the full history.

• General Ledger: this shows the charges and payments (debits and credits) associated with ALL property activity, not just the tenants. Example: it includes expenses charged and paid.

• NOI (Net Operating Income): we went through most of this in Due Diligence: Your Property Investigation Checklist. NOI = revenue minus operating expenses. NOI is used to value properties under the cap rate methodology as discussed in Cap Rates: The Simple Math of Real Estate Investing. A couple more specifics:

  • Gross Potential Rent: if all units were leased at market.

  • EGI (Effective Gross Income): all the revenue for a property beyond just rent but subtracting vacancy and collection losses.

  • Operating Expenses: day to day expenses to operate the property such as utilities, maintenance, repairs, insurance, property taxes, and property management fees. It does not include capital expenses, tenant improvements, commissions, or debt service. These are “below” the NOI and factored into the calculation of net income.

• Net Income: NOI minus capital expenses, tenant improvements, commissions, and debt service.

• Gross Receipts: the rents actually collected for a given period (ex. one month). This is typically used for the calculation of the property management fee. Example: $10,000 gross receipts x 5% fee = $500 property management fee that month.

• Income Statement: this shows the revenue, expenses, net operating income (NOI), and other activity, usually according to some chosen accounting rules like GAAP (generally accepted accounting principles). These are usually presented in a monthly format with an annual total.

• Cash Flow Statement: similar to an income statement, but this will show the actual cash activity. You may care more about the cash flow statement if you are an investor who wants regular cash distributions from your property.

• Budget: whereas income statements and cash flow statements show the actualactivity, a budget shows the projected activity. It is usually done 12-24 months at a time.

• Cap Rate and Return on Costs: I did a whole newsletter on this Cap Rates: The Simple Math of Real Estate Investing. If you are at all in doubt, I suggest revisiting it.

• Cash on Cash Return: annual distribution to investors divided by original equity. Example: $10,000 distribution divided by $100,000 original equity investment = 10% cash on cash return.

• Equity Multiple: total cash returns from an investment divided by original equity. Example: $200,000 total distributions (annual plus proceeds from sale) divided by $100,000 original equity investment = 2.0 equity multiple.

• IRR (Internal Rate of Return): time weighted calculation of all distributions to an investor, including from the sale, relative to the original equity investment. Ex. 18% IRR over the 5 year hold period.

• Hold Period: how long the investor owns the property, from acquisition date to sale date. Ex. 5 years.

• FMV (Fair Market Value): what the property could sell for today. Ex. $200,000.

• Cost Basis: total equity invested plus the loan balance. Ex. $100,000.

• Tax Basis: for income taxes based on tax rules. Remember: depreciation reduces your tax basis. Ex. $85,000.

• PSF (Per Square Foot): usually a dollar amount divided by the square footage. Ex. “I bought the property for $100 psf” or “the lease rate is $1.25 psf per month”.

• Capex: Capital improvement costs. Examples: roof replacement, tenant improvements, asphalt replacements, building painting.

Leasing

Leasing is a critical function of real estate operations. Here are the key terms to know.

• Exclusive Listing Agreement: agreement between a landlord and listing broker agreeing that (a) broker is the exclusive agent for the leasing (not necessarily the sale) of the property, (b) the fee that the listing and procuring broker will be paid when they lease the space and (c) the duration of the agreement.

• Listing Broker: broker representing the building owner aka landlord in a transaction. The listing broker markets the property on behalf of the owner.

• Procuring Broker (aka Tenant Rep Broker): broker representing the tenant or buyer in a transaction.

• MLR (Make Lease Ready) aka White Boxing: proactively performing tenant improvements to a space before there is a tenant. This helps with marketing.

• LOI (Letter of Intent): a typically non-binding agreement between owner and prospective tenant that outlines the key terms of the transaction such as lease rate, annual increases, duration of the lease, tenant improvements, options, etc.

• Lease: a binding agreement, typically 15 pages with 20+ pages of exhibits documenting in detail the terms of the lease. For industrial, office, and retail leases, this is typically prepared and negotiated with the assistance of legal counsel.

• LC (lease commissions): commission on the total base rent the tenant pays during the term of the lease (before any renewal term). Typically paid 50% upon lease execution and 50% upon tenant occupancy.

• TI (tenant improvements): one time cost at start of lease, often expressed as a certain amount psf.

• Starting Rate: initial lease rate over the term of the lease.

• Effective Rate: average lease rate over the term of the lease.

• Lease types relative to expense pass through under a lease:

  • NNN (Triple Net): typically for industrial and retail; 100% pass through of property operating expenses such as common area maintenance, property tax and insurance.

  • Base Year/Stop (typically for office): 100% pass through of expense increases over the year in which the tenant first occupied the space (e.g., at the end of the first year of the lease/base year, the actual operating expenses are calculated and become the tenant’s base year; at the end of consecutive years, the tenant will pay all amounts above the established base year amount) .

  • Gross: no pass through of expenses to the tenant. Typical for residential rentals.

  • Modified Gross: pass through of some but not all expenses directly related to the leased premises.

• MLA (Market Leasing Assumptions): key lease terms from the underwriting or budget; include starting lease rate, growth in lease rate per year, free rent, tenant improvements, make lease ready costs, commissions and lease term.

• Loss to Lease: gap between today’s market asking rents and the average in-place rent.

• Lease Trade Out: difference, usually in a %, between the previous lease rate and the new lease rate at time of renewal or replacement tenant.

• Stacking Plan: visual summary of where tenants are located in a property, usually color coded by lease expiration date.

• Rentable Square Feet: the square footage of the leased premises for which rent is charged; Includes a portion of the building’s shared/common area space. Different from…

  • Usable Square Feet: the square feet of the leased premises exclusively controlled by the tenant as opposed to part of the common area. Both used to calculate…

  • Load factor: percent increase of rentable square footage over usable square footage minus 100%. Example: “the building has a 15% load factor”.

Debt

We covered a lot of these in Debt: An Amazing Tool with Strings Attached.

• Term: the length of the loan, typically expressed in years. (e.g. “3+1+1” is a three year loan with two one year extensions.)

• Fixed Rate Loan: interest rate is fixed for the entire loan. Fixed rate loans tend to be longer than floating rate loans.

• Floating Rate Loan: interest rate changes at a fixed frequency (ex. monthly) in accordance with an index.

• Index: a specific measure that changes over time.

  • 10-Year Treasury Rate: example of an index. Comes in other durations like 1 and 5 years. Reflects the “risk free” rate because tied to the US government. 4.34% as of this writing. 3.38% as of March 2023.

  • SOFR (Secured Overnight Financing Rate): example of an index often used for floating rate loans. Replaced the index LIBOR. 3.64% as of this writing. 0.30% as of March 2022.

• Fed Funds Rate: reflects the costs banks charge each other to borrow funds overnight. When people say “the fed increased interest rates”, this is what they are referring to. The federal government uses this to control inflation (increase) and stimulate the economy (decrease). 3.64% as of this writing. 0.25% as of March 2022.

• Basis Points or “bps”: a portion of a percentage point where 100 bps is equal to 1.00%; often used in relation to the interest rate on a loan (e.g., “250 bps over SOFR” means 2.50% over SOFR).

• Point: 100 bps or 1%. (e.g., “The lender is going to charge a point origination fee”.)

• Spread: the interest rate above an index. Examples:

  • SOFR + 2.50% = 2.50% above the SOFR rate of 4.80% = 7.30% interest rate (floating rate).

  • 5-Year Treasury + 1.90% = 1.90% above the treasury rate of 3.30% = 5.20% interest rate (fixed rate).

• Origination Fee: fee charged by a lender to give the loan.

• Interest Only Loan: a loan without amortization (repayment of principal each month).

• Amortizing Loan: a loan with amortization (repayment of principal each month).

• Hedge: typically a cap or a swap.

  • Cap: an agreement between a borrower and a 3rd party to establish the maximum amount a floating rate index (SOFR) can increase. (e.g. a 6.00% cap on SOFR for 2 years). The borrower pays a one-time fee to the 3rd party providing the cap.

  • Swap: an agreement between a borrower and a 3rd party to convert a floating rate index (SOFR) to a fixed rate for a specific period of time. Money is exchanged between parties whenever the index adjusts. Both parties are making a bet on whether interest rates will increase or decrease. A borrower may want a swap to reduce uncertainty.

Equity and Joint Ventures

We haven’t gotten to equity and joint ventures yet, but here is a preview for some of the terms we will cover.

• GP (General Partner) or Operator: company or individual that operates the property day to day.

• LP (Limited Partner) or Equity / Money Partner: company or individual that provides money to buy the property. They could have many or no approval rights.

• Major Decisions Rights: rights the LP has to approve certain decisions. 

• JV (Joint Venture) or LLC (Limited Liability Company) Agreement: agreement between GP and LP that details all the terms under which the partners will operate. 

• SPE (Special Purpose Entity): legal entity, typically a limited liability company (aka LLC) that the partners are members of through which they own the property. They use this to shield their liability exposure to just this investment.

• Entity Organizational Chart: boxes and arrows showing the legal ownership structure.

• Signature Block: legal structure of entities authorized to sign on behalf of the legal entity.

• Fees: fees paid by the property to the operator for certain functions. These are negotiated between the GP and LP. These fees and functions are in addition to those performed by a broker. All investors (both GP and LP) pay the fees. Examples are shown in the table below.

Table: Example Fees Charged by a GP

• Promote: money that the GP earns if the investment does very well. Example: GP invests 5% ($50K) of the $1M equity required. LP invests $950K. GP gets 20% of all proceeds above an 8% IRR.

What to Make of All These Terms

Is your head spinning yet?!

You just read a glossary of real estate terms. Well done!

Will there be a test? 

No.

But…

You will come across many of these as you invest and work in the commercial real estate industry. You will remember some and forget others. 

Just know that this set of information is here for you when you need it. Download an editable file of the glossary on the downloads page.

Add to it as you discover new terms.

Remember that the key is to pay attention, be patient, and ask questions. Asking questions is not a sign of ignorance. It is a sign of being a learner. This is a good thing.

Always be learning!

Closing Day: What to Expect

Documents, money flow, and key takeaways for your first closing

Over the last four weeks we have covered four topics on acquiring (aka buying) an investment property. 

• Finding Your First Real Estate Deal: A Step-by Step Guide

• Demystifying Real Estate Purchase Agreements

• Due Diligence: Your Property Investigation Checklist

• Debt: An Amazing Tool with Strings Attached

Now we are going to get into what happens during the actual closing, when ownership transfers from the seller to the buyer.

This will be the 5th and final newsletter on the acquisition process. Next week we will transition to how to own and manage your property.

Last week’s discussion on debt was long. This one is going to be shorter as it is a fairly straightforward process with far fewer moving parts.

Essentially, the closing process involves two things:

1. The exchange of money.

2. The signing of documents to legally transfer ownership.

Let’s dig in.

What is Closing?

When I talk about “closing”, I am referring to the day in which money and ownership transfer between the seller and the buyer. 

Due diligence has been completed.

The buyer has gone non-refundable with their deposit and the closing date is here.

What happens next?

Here’s a typical closing timeline:

• 3-7 days before: finish up loan documents.

• 1-3 days before: sign documents.

• 0-3 days before: buyer and lender wire money into escrow. Bind insurance.

• 1 day before: final review of closing statement.

• Closing day: last minute document signing and any other issues.

• 0-2 days after: notify tenants and vendors; record deed with the county.

The actual “closing day” can be anticlimactic as it may feel like you are just waiting for the escrow officer to say “we are closed”.

The Role of Escrow

As discussed in Demystifying Real Estate Purchase Agreements, the escrow officer at the escrow company plays the “referee” and lead coordinator of the sale process. 

They make sure all the documents get signed and sent to them. 

They arrange the legal recording (aka evidence) of the sale.

They also hold and distribute the money.

In short, they make it all happen.

Documents Get Signed

As also discussed in Demystifying Real Estate Purchase Agreements, there are a number of “form” documents that were agreed to in the purchase and sale agreement (“PSA”) and added as exhibits.

These “form” documents are then used as templates to create the actual documents that formalize the sale.

They include:

• Grant Deed: this is the legally recorded document that confirms the property has been sold. Recording the document with the local municipality allows everyone to see that the property has been sold.

• Bill of Sale: this documents the sale of any personal property related to the physical property. Examples: parts and materials for repairing the property such as flooring or light bulbs.

• General Assignment: this documents the transfer of the various contracts such as leases, warranties, and service contracts.

There may also be other documents signed such as the one that notifies the county property tax assessor of the sale.

If the buyer is getting a loan to buy the property there will also be:

• Deed of Trust: the legally recorded document that shows there is a loan on the property.

• Loan Agreement and related documents: each lender has their own set of documents that they like to use.

In addition to documents getting signed, money will need to change hands.

Money Exchange

If both the buyer and the seller each have a loan on the property, then there will be five parties giving and/or receiving money.

These are the parties and this is the typical order in which money flows. Everything goes through escrow.

1. $ Into Escrow: Buyer sends in their equity.

2. $ Into Escrow: Buyer’s lender sends in their loan funds. They want to see the buyer’s money in first.

3. $ Out of Escrow: Seller’s lender receives money to pay off the seller’s existing loan on the property.

4. $ Out of Escrow: Payments to inspection vendors, escrow, title, and lawyers.

5. $ Out of Escrow: Seller receives the balance of the sale proceeds.

Here’s a diagram to help you understand.

Diagram: Flow of Money at Closing

Escrow officers make it all happen. 

Closing day is stressful for all parties. Escrow officers live this every day! Be kind and patient with them.

Let’s move on to another critical component relative to money moving around: closing statements.

Closing Statements

Closing statements show who is getting paid what. There will be at least two closing statements:

• Buyer’s Closing Statement

• Seller’s Closing Statement

Think of them as an excel sheet showing “charges” and “credits” and ending in a total of how much the buyer and seller will owe and receive, respectively.

Ex. Buyer’s Closing Statement

• Charges (amounts buyer has to pay)

  • Purchase price

  • Legal fees

  • 3rd party fees for inspections

  • Escrow and title fees

  • Loan fees

  • Prorations*

• Credits (amounts that reduce the buyer’s cash needs to close)

  • Deposits already made during due diligence

  • The loan

  • Prorations*

• Total: at the bottom it will show how much cash the buyer will need to send into escrow to be able to close the deal.

*See discussion below for the meaning of “prorations”.

Here’s what the math would look like based on our ongoing example discussed in previous newsletters.

Diagram: Example Buyer’s Closing Statement

The amounts in italics would not be part of the closing statement. I added it to show the total equity the buyer actually funds which is:

• $54,612.50 - amount due at closing to escrow

• $ 4,950.00 - previously paid deposit

• $59,562.50 - total equity paid to escrow

So why doesn’t it equal exactly $60,000 from our previous newsletter discussions?

Because of “prorations”.

Prorations

Prorations are the split of rent and operating expense between the buyer and the seller based on (a) the days of that month the buyer and seller will each own the property and (b) the timing of the rent or expense.

Simple example used in the closing statement above: you close on June 16th, halfway through the 30 day month.

Rent Proration

• Tenant paid $1,200 rent to the seller on June 1st.

• But the buyer (you) owns the property June 16th to 30th (16 days).

• Seller owes you the rent for your 16 days: $1,200 x 16/30 = $600.

• This $600 is credited to you on the closing statement.

Operating Expenses

• Buyer paid $625 in operating expenses on June 1st.

• But the buyer (you) owns the property June 16th to 30th (16 days).

• You owe the seller for your 16 days: $625 x 16/30 = $162.50.

• This $162.50 is charged to you on the closing statement.

Here are some things to note on these calculations:

1. Buyer’s ownership of the property starts on the day of closing, in this example the 16th of a 30 day month.

2. Prorations are based on amounts actually collected (rent) and paid (operating expenses) by the seller. If the tenant hasn’t paid the rent yet that month, the rent is not prorated. This often happens when the closing occurs in the first five days of the month. Same concept for operating expenses.

3. Insurance is not included in the proration as the buyer will need to get their own insurance. This is often paid through closing. Ask your insurance broker as the amount paid through closing will often be 6-12 months of premiums.

4. Not all operating expenses are paid monthly. This is especially true for property taxes. The proration will be adjusted for the timing of the payments.

Don’t worry if this is confusing. The escrow officer will do all the math.

What Happens Immediately After Closing

Once closing is complete, a number of things will happen right away.

• Receive keys or access codes

• Change locks (important for security)

• Transfer utilities to your name

• Contact tenants to introduce yourself and send them notices with contact information and rent payment instructions

• Set up property management/accounting and maintenance vendors

This is because YOU are now the property owner! 

Congratulations!

So what do you takeaway from all of this? 

Key Takeaways

The closing process is when multiple parties come together to formalize the closing. Here’s what you should remember.

1. The escrow officer makes it all happen. They are the referee and the coordinator.

2. You will need to sign many documents: make sure your government-issued photo ID is current. Documents include:

   1. One set to buy the property.

   2. One set if you are getting a loan on the property.

3. Be 100% available the day before and of closing. There are often last minute documents that need to be signed. Sometimes they cannot be signed electronically, so it is ideal to have a local escrow company.

4. Many closings now happen remotely using electronic signatures and wire transfers. You may never meet your escrow officer in person. This is normal and perfectly safe - just verify wiring instructions carefully.

5. Scammers impersonate escrow officers and send fake wiring instructions. ALWAYS call your escrow officer at a verified number to confirm wiring details before sending money. Never rely on emailed wiring instructions alone.

6. The amount of cash you send to escrow will likely be different than the amount you have in your internal analysis. The difference will be prorations. Most of the time this is a minor issue, but property tax prorations can be big. So can the initial insurance payment. Talk to your escrow officer well in advance to understand this. You can also do the math yourself.

7. As discussed last week in the newsletter on debt, lender reserves can significantly reduce the amount of initial funding from the lender. A $110,000 loan with $10,000 of reserve holdbacks will only result in $100,000 of funds at closing. Read the loan documents. Understand this in advance. It is no fun to be jammed on the day of closing by not having enough cash to close because of reserve holdbacks by the lender that you should have known about.

8. Closing can get delayed for multiple reasons: title issues, lender funding delays, missing signatures, wire transfer problems, and other last minute issues. As long as all parties are reasonable and want to make the deal happen, you will be able to overcome these issues.

9. Stay calm and carry on. It will be stressful, but you will get through it. Don’t get frustrated and send a nasty email you will regret.

You’ve got this.

Follow the lead of your escrow officer (and lawyer if you are using one).

You will complete the closing and own your first property.

Owning the property is where the fun and work really begin. 

That is the series we will begin next week.

Debt: An Amazing Tool with Strings Attached

How loans work, what lenders charge, and how to use leverage wisely

Debt. Loan. LTV. Lender.

These are all terms relating to borrowing money to own a property.

If you own a home as your primary residence, chances are that you have a loan on the property.

Why?

Because debt allows you to buy something that costs more than you can afford at that moment in time. It relies on at least two things:

1. People want more stuff. A bigger house. A bigger investment. Better returns.

2. There are groups willing to lend people money to get that stuff in exchange for a promise of future payments.

Here are two examples:

First Time Home Buyer

You want to buy a $170,000 home, but you don’t have $170,000. You have built up $60,000 in cash, but you need another $110,000 to buy the home. 

Enter the lender. 

The lender, often a bank, will loan you the $110,000 in exchange for an agreed upon set of future payments over 5-30 years, inclusive of a certain interest rate and fees. The interest rate and fees are how the lender makes money.

They will do this based on your personal income profile (salary, bonus) and personalcredit score. This is how they determine how risky you are as a borrower.

Investor Buying an Industrial Building

There is a similar structure when you are buying a commercial building with two main differences: (1) how the lender determines risk and (2) how long a loan they will give you.

With a commercial building, the lender looks at the property (in this example the industrial building). They value (aka appraise) the property and look at the income the property generates to make the monthly debt payments. Additionally, they will only give you a 2-15 year loan.

Stay tuned. I will explain this in more detail.

We will cover the basics of debt including:

1. How a lender makes money.

2. The niches lender have - just like investors do.

3. The types of lenders that focus on real estate investment properties.

4. How a lender determines how much to lend and what interest rate to charge.

5. The typical timeline to close a loan.

6. The benefits and risks of borrowing money to own real estate.

7. Professor Bateman’s key takeaways.

Let’s dig in.

How a Lender Makes Money

Lenders make money in three ways: (i) fees, (ii) interest, and (iii) by getting paid back at the end of the loan term.

#1 Fees: Fees are one-time charges lenders make to the borrower. Examples include:

• Origination Fee: To give you the loan.

  • When: At the time the loan is funded to the borrower.

  • Amount: A percentage of the loan amount. Ex. 1% of $110K = $1.1K.

• Extension or Payoff Fee: A time of extension or payoff.

  • When: At the time the loan is extended or paid back.

  • Amount: A percentage of the loan amount. Ex. 1% of $110K = $1.1K.

• “Processing Fee”: this is a catch all for the many fees lenders may charge such as underwriting fee, processing fee, application fee, credit fee, appraisal fee, legal fee.

  • When: At the time (or before) the loan is funded to the borrower.

  • Amount: These are normally specific dollar amounts. Sometimes they are to reimburse the lender for fees they are paying a 3rd party such as an appraiser or lawyer. Make sure to ask what fees the lender will be charging.

• Broker Fee: this is when a broker helped find you the lender and the loan. The fee goes to the broker, not the lender.

  • When: At the time the loan is funded to the borrower.

  • Amount: Typically a percentage of the loan amount. Ex. 1% of $110K = $1.1K.

#2 Interest: Interest is the ongoing amount that the lender charges the borrower for the loan. Ex. 7% per year. 

7% x $110K = $7,700 per year. Divide by 12 to get the monthly amount of $641.67.

There are two important factors to consider with interest rates, as there are different structures with different types of loans.

• Fixed vs. Floating Interest Rate

  • Fixed: The interest rate remains the same for the entire loan.

  • Floating: The interest rate changes during the loan, normally based on a fixed amount (ex. 3.50% - known as the “spread”) over a publicly available benchmark such as SOFR or Prime. Ex. If SOFR is at 4.00% and the spread is 3.50%, then the interest the borrower pays is 7.50%. If SOFR increases to 5.00%, then the borrower’s interest rate goes to 8.50% (5.00% SOFR + 3.50% spread).

  • Why this Matters: You get interest cost stability with a fixed rate loan. With a floating rate loan, you are adding an element of risk (both upside and downside) to your investment based on what interest rates do.

• Interest Only vs. Amortizing

  • Interest Only: Each month the borrower only pays the interest costs.

  • Amortizing: In addition to the interest costs, the borrower also pays down the principal balance (i.e. a portion of the $110K loan) each month. This makes the borrower’s monthly payment more than an interest only loan payment.

  • Why this Matters: If you are tight on cash each month, an interest only loan can help a lot, but you will have to pay the full loan amount back at the end of the loan. In an amortizing loan structure, you will “chip away” at the principal balance each month.

#3 Getting Paid Back at the End of the Loan: this one is fairly obvious. If the borrower doesn’t pay the lender back at the end of the loan, then the lender is not going to make money.

To summarize the three ways lenders make money:

• Fees

• Interest Rate

• Getting Paid Back at the End of the Loan

Keep in mind that a lender is not an equity investor. They are not going to benefit from the property being a home run.

In exchange for a lower return, they have lower risk. If the property goes bad and the borrower can’t make interest payments, the lender can take over ownership of the property. This is called foreclosing and the investors lose all their money.

Low risk, low return, better protection. It is a fair trade-off.

Lenders Have Niches Just Like Investors Do

Just as investors pick a niche, lenders pick one or more niches to focus on. Let’s oversimplify a bit and say there are four niche criteria for lenders:

• Asset Class: 1-4 unit residential, multifamily, industrial, retail, office.

• Geography

• Strategy: core/turnkey, light rehab, value add, development.

• Recourse vs. Non-Recourse

We should be familiar with the first three as discussed in Stop Chasing Every Deal: Why Successful Investors Pick a Niche.

The fourth one is unique to lending: recourse vs. non-recourse.

A recourse loan means that you are personally responsible to pay back the loan. If you get a home loan, it is almost certain that it is a recourse loan.

A non-recourse loan means that you are not personally responsible to pay back the loan (unless you commit fraud or there is an environmental issue). If there is an issue with the non-recourse loan in the industrial building example, the lender can’t come after your personal assets (cash, home, stock, other real estate, etc.)

In an ideal world, as a borrower you would only get a non-recourse loan.

Why? Here’s an example of a recourse loan gone bad.

You buy a $500K property with $400K loan. The market crashes and the property is now worth $300K. You can't make payments. The lender forecloses AND can come after your personal savings, home, other assets for the $100K shortfall ($400K loan amount less $300K current value).

With a non-recourse loan the lender can only look to the $300K property value, not your personal assets.

So why do some borrowers get recourse loan? For several reasons:

• Scarcity: It may be the only type of loan available. There is not a non-recourse option. This is almost always true if you are doing a new development.

• Economics: The loan has better economics than the non-recourse option (fees, interest rate, loan amount/proceeds).

• 1-4 Unit Residential: Lenders view 1-4 unit residential investment properties as personal properties by relying on a borrower’s personal income and credit score. This can be helpful if you are a first time buyer.

Let’s do a quick sidebar to point out three characteristics of loans for value add and development deals, as they are the highest risk and lenders treat them differently.

1. Loan Term (aka Length): Loans for these type of investments tend to be shorter - say 3-5 years. They are often called “bridge” loans. The idea is that they are more temporary in nature as the property is in transition. 

2. Floating Interest Rate: For the same reasons as the loan term, these are more likely to have a floating interest rate.

3. Reserve Holdbacks: These are funds the lender “holds back” from the initial loan funding to pay for future costs such as construction, leasing, and even interest rate reserves. This reduces the amount of the loan at closing and allows the lender to make sure you spend their money on what you said you were going to spend it on.

So who are these mysterious “lenders”?

Types Of Lenders

There are four main types of lenders:

• Banks & Insurance Companies

• Debt Funds

• Securitized

• Fannie Mae and Freddie Mac (Government Sponsored Enterprises)

Banks & Insurance Companies: These groups lend their own money. Both have excess cash they want to earn a return on: banks from deposits and insurance companies from insurance premiums.

Debt Funds: Debt funds raise money from various investors such as pension funds, insurance companies, and university endowments. Debt funds tend to do riskier loans than banks in exchange for higher interest rates and fees.

Securitized: Securitized lenders function differently in that they plan to sell the loan to one or more investors after the loan closes. They effectively act as a middleman earning a fee. Sometimes they are mainly concerned with how the loan will be viewed by the ultimate buyer of the loan. Watch or read The Big Short to see this go to the extreme.

Fannie Mae and Freddie Mac: Fannie and Freddie are government sponsored enterprises created by congress to support the U.S. housing market (residential properties only). Similar to a securitized loan, a lender originates the loan and then the lender sells the loan to Fannie or Freddie. This allows the original lender to have more money to make new loans. Don’t worry about the details. Just know that they exist.

Key Takeaway: If you are a first time investors, you will likely work with a bank.

With that covered, let’s get to the next big question of how lenders evaluate a loan.

How a Lender Determines How Much to Lend and What Interest Rate to Charge

So how do they do it? With a magic lender calculator?

Quite simply: by assessing risk and pricing accordingly.

More risk, more costs to the borrower.

Assuming the property fits in the lender’s niche, the lender will generally (a) charge more fees and a higher interest rate and (b) provide a lower loan amount for properties the lender views as riskier. 

Here’s an overview of the financial tools a lender uses to assess risk:

• Appraisal: An appraisal is an assessment of the fair market value of a property as determined by some combination of (i) replacement / construction cost, (ii) similar properties that have sold recently aka “sales comps”, and (iii) the capitalized value. It is completed by a licensed third party appraiser.

  • The lender will normally have some max amount of appraised value they will lend up to. Ex. 65%. This is referred to as the “loan-to-value” or “LTV”. Here are some LTV rough guidelines. More risk to lender = lower LTV = more equity/cash you need.

    • Primary residence: 80-97% (3-20% equity)

    • Investment property (1-4 unit): 75-85% (15-25% equity)

    • Commercial (turnkey): 65-75% (25-35% equity)

    • Commercial (value-add): 55-70% (30-45% equity)

    • Development: 50-65% (35-50% equity)

• DSCR: This stands for debt service coverage ratio. Think of this as the lender’s “cushion” in the property’s ability to generate enough income to pay interest. Mathematically it is NOI divided by Interest Costs. Ex. A property generates $10,000 NOI. Loan is $110,000 at 5.5% interest = $6,050 annual interest. DSCR = $10,000 / $6,050 = 1.65x. 

  • The lender normally wants this to be at least 1.20. Remember, they are in the low risk, low return business.

• Debt Yield: Think of this a the lender’s cap rate. Mathematically it is NOI divided by Loan Amount. Ex. $10,000 / $110,000 = 9.1%.

  • The lender will have a minimum target.

• Personal Credit & Income: If a recourse loan.

Each lender has their own special formula or hot buttons they use based on some combination of these criteria.

Side note: did anything stand out to you relative to the LTVs above? Even on the riskiest deals, they are all 50% or higher. This means the lender is funding 50%+ of the cost of each real estate investment. The real estate industry would be very different without their support. Thank you to all the lenders out there!

So how long does it take to get a loan? That is our next topic.

Typical Timeline

• Finding the right lender (1-4 weeks).

• Negotiating a term sheet (1-2 weeks).

• Negotiating the loan agreement (1-4 weeks).

• Closing the loan (1 week).

• Total 4-11 weeks (plan for 6-8 weeks typical).

This can be tight if you don’t start the process until you are already under contract to buy a property, especially if it is your first deal.

Remember that your due diligence period may only be 30 days. You don’t want to be in position where you put your deposit at risk by going non-refundable without certainty on your loan.

Start early. Establish relationships with potential lenders that fit your niche before you have your first property. This will make the whole process much easier.

Now that we have a basic foundation, let’s zoom out a bit to talk about debt on real estate in general.

The Benefits and Risks of Borrowing Money to Own Real Estate

So should you get a loan to buy real estate?

The reality for most new investors is that they will end up getting one to be able to afford their first property. And most seasoned investors will see too much benefit to their returns and scale to not want to borrow.

There are two main benefits to real estate loans:

Benefit #1 - Lower Equity Requirement

You don't need to have or raise as much equity when you have a loan for 50% to 75% of the amount needed to buy a property. An investor may simply not be able to come up with the cash needed to buy a property without a loan or they may want to buy more with the money they have.

Benefit #2 - The Power of Leverage

Leverage is the mathematical and financial benefit of borrowing money at a cheaper rate than the rate of return for the equity investors. If you borrow money at 5.50% and can earn 9.0%, then you have positive leverage. 

9.0% earnings is greater than 5.50% cost of borrowing.

Positive leverage is a good thing because you are earning more than the cost of your interest rate.

If you borrow money at 5.50% and can earn 4.50%, then you have negative leverage.

4.50% earnings is less than 5.50% cost of borrowing.

Negative leverage is a bad thing because you are being charged more than you can earn.

If you are a professional real estate GP raising money from LPs you will find it hard not to use debt to be competitive in the marketplace to raise LP capital. 

When you believe your investment can earn a 9% total return (IRR) over the full 5-10 year investment, it is too tempting not to turn that into a 12%+ total return by adding positive leverage.

So what are the negatives of borrowing money?

Negative #1 - Increased Risk

Borrowing money increases your risk by (i) increasing your monthly costs in the form of interest payments and (ii) requiring you to pay back the full loan amount on a specific date. Things don’t always go as planned. 

Did you know the Empire State Building was under construction at the start of the Great Depression of the early 1930’s? The developer was able to finish the development and keep ownership of the property partly because he built it all cash without debt. If he had a loan, he would have almost certainly lost it to the lender at some point.

Negative #2 - Reduced Control

Not only will the lender charge fees and a monthly interest rate, but they may also have certain approval rights for things like larger leases, major capital improvements, and other operating choices. You limit what you can do when you have a loan on the property.

So what do you make of everything I have discussed here?

Professor Bateman’s Key Takeaways Regarding Debt

1. Understand that debt and leverage can be a wonderful tool to boost returns, but come with added risk and costs.

2. Accept that you will likely need a loan on your first deal.

3. Start early and identify lenders in advance. Not all lenders are created equal. Take the time to find the lender that fits your property profile. Using a debt broker can help.

4. Form relationships with good lenders to do repeat business.

5. Become familiar with the lender’s perspective on DSCR, debt yield, and appraisals. This will help you speak their language.

6. Look beyond just fees, interest costs, and proceeds. These are the financial cost of debt, but there may be operational implications and restrictions. Think about what is most important to you on a particular deal.

7. Be careful with floating interest rates and short-term loans. These can lead to challenges. 

8. Watch out for pre-payment restrictions or penalties if you pay the loan off early. These limit your flexibility.

9. Understand reserve holdbacks may reduce your initial loan amount. Ex. A $110K loan with $15K of reserve holdbacks results in $95K of initial loan proceeds. This could mean more equity is required up front to close the loan.

10. Become familiar with loan documents. Learn more on my downloads page.

11. Acknowledge the benefit of working with lenders that hold the loans “on their books”. Be eyes wide open on whether the lender will sell / securitize the loan after they make it. Challenges will happen during the loan term. It is a lot better to be able to work problems through with original lender than one that bought it from that lender.

12. Avoid recourse loans when you can. You may need to take on recourse for your first duplex, but set a goal to avoid it as soon as you are financially able. One bad recourse loan could personally bankrupt you. 

In my opinion, owning a property debt free without any LP investors is a fantastic place to be. It gives you the ultimate freedom.

You may not be able to start there, but I encourage each of you to think of it as a goal worth considering over the long term.

Professor Bateman

Due Diligence: Your Property Investigation Checklist

What to review before your deposit goes non-refundable - from leases to roofs

Due diligence.

Another piece of jargon from the real estate industry.

What does it mean? 

In plain English: 

Due diligence is the process of doing the investigative work to determine if what you think you are buying is what you are actually buying.

It is a way to minimize risk and avoid costly surprises.

If you are buying a 1-4 unit residential property, it is known as your inspection period. 

If you are buying a commercial property, it is known as due diligence or “DD”.

You do this in the period of time before your deposit goes non-refundable, as detailed in last week’s discussion: Demystifying Real Estate Purchase Agreements

If you have bought a used car, you have experienced due diligence. You take the car for a test drive. Hopefully you followed up with an inspection or at least outsourced the inspection process by buying a “certified pre-owned” car from a dealer who completed the inspection. Maybe you even read the Carfax report.

All of this was done to determine if the car would drive OK once you owned it.

Same concept with buying real estate.

You want to make sure that you do what you can to confirm your investment property will perform as you expect it to perform.

How do you do this?

I like to use a simple cash flow statement to determine what to look for. Think of the cash flow statement as your guidebook. 

By tying (almost) everything back to the cash flow statement, you minimize the risk of surprises. 

Today we’ll cover:

• How to use a cash flow statement as your due diligence guide

• What to review for revenue (rent, vacancy)

• What to check for operating expenses (utilities, insurance, property taxes, management fees)

• How to evaluate capital improvements (capex, renovations, tenant improvements)

• Non-cash flow items (zoning, title, environmental)

• Simple vs. complicated properties 

Let’s dig in.

Reminder: Refundable vs Non-Refundable

Last week we talked about the difference between the refundable (aka contingency) and non-refundable period. Let’s anchor on this concept again.

• Refundable: From the date the Purchase & Sale Agreement (“PSA”) is signed through the expiration of the due diligence period, the buyer can typically back out of the deal for any or no reason and get their deposit back. No penalty. No foul. They still have to pay the consultants and advisors they may have hired and their reputation may suffer, but they don’t have to buy the property nor forfeit their deposit.

• Non-Refundable: Once the due diligence period expires, everything changes. The buyer can still back out of the deal, but doing so will mean they lose their deposit. 

Due diligence is one of the most important things the buyer does during the refundable stage of the acquisition process.

Cash Flow Statement as a Guide

Let’s continue our property example from one of my previous newsletters: Unlocking Value: What to Do After You’ve Improved Your Property. You are buying a property with $10,000 of net operating income (“NOI”). You believe you can perform a $30,000 light rehab to increase the NOI to $15,000.

In the table below, I have expanded our example to include some assumptions on the revenue and expenses to build up to the NOI.

Revenue less operating expenses = Net Operating Income.

Table: Light Rehab Property - Annual NOI Comparison

Let’s define each line item.

Revenue

• Rent: what is paid by the tenants under the leases.

• Vacancy / Credit Loss: an assumption that the property will not be leased the full year and/or the tenant will not pay rent and you will need to evict them at some point.

Operating Expenses

These are your recurring costs to operate the property, regardless of whether you have a loan on the property or not.

• Utilities: any utilities the tenant doesn’t pay. Remember that you will have to pay utilities in the time between one tenant moving out and the next one moving in.

• Repair & Maintenance (“R&M”): you may need to pay for some costs even if the tenant is leasing your property. Example: plumbing repairs.

• Insurance: property and liability insurance.

• Property Taxes: these are determined by the state and county in which the property is located.

• Property Management Fee (“PM Fee”): if you are using a 3rd party to manage the property, you will need to negotiate what fee you pay them. Some GPs choose to act as the property manager and charge a PM fee.

Let’s run through how we can use this as a guide for our due diligence.

Revenue: Rent

There are two ways to look at rent: in place and market.

In place rent is determined by any leases for current tenants. The due diligence process involves reading the leases to confirm the rent and rent increases, any additional rent charges (ex. monthly utility reimbursements), the lease expiration, and any renewal options. 

You will also want to note any landlord obligations (ex. replacing an HVAC unit by a certain date), any tenant obligations, and any other items that could affect the performance of the property. 

Ideally you will want to interview the existing tenants to ask them how they like the property and if there are any problems with it and/or the landlord.

Market rent is totally different. 

You will need to talk with brokers to get their opinion of market rent. In the example above, you are doing the light rehab so you want to talk with multiple brokers to get their opinion on what they think the property will lease for after you complete the light rehab.

Revenue: Vacancy / Credit Loss

Understanding the market and the likelihood (and duration) of vacancy will come from your conversations with the brokers. Simply ask: “How long do you expect the property to be vacant after I complete the light rehab?” By asking multiple brokers the same question, you will develop your own opinion.

Credit loss will be a combination of (a) reviewing the rent payment history of the existing tenants and (b) making an assumption. To review the existing tenants, the seller should provide you an “accounts receivable” report showing any rent that hasn’t been paid by the existing tenants. This is often referred to as the “A/R report”.

Ideally you also get a copy of the “tenant ledger” for the last 3-12 months which shows the payment history and timing of all tenant charges and payments, regardless of whether they currently owe delinquent rent or not. This is key to seeing when the tenants pay each month. 

Your loan payment will likely be due in the first 5-10 days of the month. If your tenants don’t pay until the 20th, you will need to build up more cash to be able to pay the loan payment before you get the rent.

Operating Expenses: Utilities, R&M

These are determined by multiple methods:

• Review of the seller’s historical income statements: ideally past two years. You want to see what has been paid in the past to determine the future.

• Review of any service contracts in place. Examples: pest control, landscaping. The contracts will list the monthly payments amounts.

• Review of historical utility statements. This will allow you to see the seasonality of the charges so you can do a monthly cash flow. It will also show you if there were any unusually high or low months. You will want to investigate these. Example: there may have been a water leak that caused the water bills to be high one month.

Operating Expenses: Insurance

You will need to get your own insurance for the property. You can’t use the seller’s insurance. Get quotes for property and liability insurance from an insurance broker. Property insurance if for physical damage to the buildings. Liability insurance is to protect you if get sued.

Operating Expenses: Property Taxes

Property taxes are determined by each state and administered at the county level. 

Each state has a different method of calculating property taxes as well as a different frequency at which the amount of the property taxes are both paid and recalculated (aka re-assessed). 

Review the seller’s property tax bills. Talk with the county assessor’s office and/or a property tax consultant to determine the specifics of that state and county.

Don’t assume your property taxes will be the same as the seller’s. Every state has different rules.

Operating Expenses: Property Management Fee (“PM Fee”)

The amount of the PM fee will be based on a new contract you negotiate with whomever you hire to manage the property and do the property accounting. It could be the same party as the seller used. It could be a new group.

Fees range from 1% - 8% of revenue depending on the size and complexity of the property.

NOI = Revenue minus Operating Expenses

That’s it. 

You have done the due diligence to validate NOI. Well done!

But we are not finished yet.

Now let’s move on to the “below the NOI” items by discussing capital improvements.

Capital Improvements

Capital improvements are physical improvements to the buildings. They fall into three main categories: 

1. Capex: repairing or replacing existing building systems such as the roof or HVAC in a “like for like” way.

2. Renovations: upgrading the existing building with light rehab or value add improvements.

3. Tenant Improvements & Leasing Commissions: costs to customize a space for a specific tenant and pay a broker commission for finding the tenant.

Capex

Due diligence is done on capex by:

• Hiring consultants to review the existing building systems.

• Getting bids from contractors for specific work. 

Some consultants specialize in property condition assessment (aka property inspection or PCA) reports. They will give you an overview of the condition of the property with rough cost estimates by year. 

But they won’t actually do the work to repair the property.

You need to get specific bids for the work from someone who will actually do the work.

This is key.

If the PCA says the roof needs to be replaced in the first three years, talk with a roof vendor to confirm this assumption and tell you how much it will actually cost if you engage that roof vendor to do the work. 

This is where you get real pricing.

Renovations

You have a plan for what you want to do in your light rehab. Hopefully you validated and/or evolved it by talking with local brokers. 

Now you need to price it out. 

Just as you did with the roof vendor, meet with a contractor who will price out the light rehab and tell you a realistic time frame to complete the work.

Tenant Improvements & Leasing Commissions

This also comes from conversations with local brokers. 

• 1-4 Unit Residential & Multifamily: there will be no or minimal tenant improvement. 

• Commercial (office, retail, and industrial): tenant improvements are very common. So are leasing commissions. Talk with local leasing brokers to develop realistic estimates. These are often significant ongoing costs for office and retail properties. 

Non-Cash Flow Due Diligence

Although everything has the risk of ultimately impacting the property cash flow, there are some items that fall outside our “cash flow statement as a guide” concept. 

These generally have the commonality of making sure you can operate the property as expected without interruption from the local municipality.

• Zoning: check with the city to confirm the legal zoning for the property and that the property you are buying conforms with that zoning.

• Title: most properties have some legal rights placed upon them by 3rd parties. Example: the local utility may have an easement to bring their electric lines to your property. The title report and the ALTA survey will tell you these.

• Environmental: if you are buying an industrial or retail property, getting an environmental report is critical. You want to see if there are any issues (ex. old dry cleaner or manufacturer that contaminated the soil). There are consultants that specialize in this and create a “Phase I” report to summarize the environmental condition of a property.

Bringing it All Together

If this feels to you like a lot to review, then you are correct. It is a lot. 

A typical due diligence timeline might be:

• Week 1: review materials, order reports (PCA, title, environmental)

• Week 2: property inspections, broker interviews

• Week 3: review reports, contractor bids

• Week 4: update your financial analysis and make final decisions

Things move fast. You owe it to yourself to be thorough so you need to be focused, prepared, and methodical. Don’t cut corners.

Here are some common issues that might come up in your due diligence:

• Major capex discovered (immediate roof replacement)

• Tenants not paying rent (A/R report shows major delinquencies)

• Zoning violations (the property cannot be operated as is)

• Environmental contamination (discovered in the Phase I report)

• Title problems (liens, easements that restrict use)

Sometimes these can be negotiated with a price reduction or time to fix an issue. Sometimes they kill a deal.

If you find a problem, be transparent and solution oriented with the seller. You want to find solution that works for all parties. 

Do I Really Have the Time for This?

If you are intimidated by the time involved, note that not all properties require the same level of time in your due diligence review. 

Let’s give two examples.

Simple: 2-Unit Residential in Established Neighborhood

• Revenue: there are just two leases to review. It is in a neighborhood with a lot of similar properties, some of which have been rehab’d and some of which have not. There are lots of similar properties to reference and talk with brokers about.

• Capital Improvements: all you really need to do is confirm the condition of the property and price out your light rehab.

• Non-Cash Flow Due Diligence: this will be straightforward as there shouldn’t be any issues.

Complicated: 50 Year Old Industrial Building with 50+ Tenants

• Revenue: lots of leases to review. If the units are different sizes and configuration, determining market rent for each will also be complicated.

• Capital Improvements: the building systems are old. There may be a variety of tenant improvements that are unique for each suite.

• Non-Cash Flow Due Diligence: this could be complicated. Zoning may have changed over time. There is also risk of environmental issues.

In the simple example, you should have plenty of time to complete the due diligence before the period expires.

In the complicated example, you will be working non-stop to get it done.

Walk Before You Run

If you are new to real estate investing, start simple. 

The complicated example may look attractive from a theoretical cash flow perspective, but the due diligence will be hard and full of risk for a new investor.

And remember, there are other things you will need to do before your due diligence period expires. 

If you are getting a loan to buy the property, this will consume a lot of your time. You need time to figure this out and get the right loan.

Set yourself up for success by starting with a simple property.

Get in your reps. 

Become an expert in due diligence. 

What you learn in the due diligence process will form the foundation of your understanding of the property and pay dividends in the future. 

Take the time to do it right.

For those of you that want to dig deeper, there are more resources on my downloads page.

Professor Bateman

Demystifying Real Estate Purchase Agreements

What's in a Letter of Intent and Purchase & Sale Agreement - and why you shouldn't be intimidated by them

Last week we discussed the process of finding your first real estate investment.

• Building market knowledge.

• Establishing broker relationships.

• Finding and analyzing the right property for you.

The process is simple, but by no means easy. It requires focus and persistence.

Stick with the process. You will find a deal that works for you.

But what do you do once you have found a deal you want to buy?

Do you tell the broker or seller you are interested in buying the property?

Yes!

Do you have to send them something in writing?

Yes! A letter of intent.

Will you have to sign a legally binding document?

Yes! A purchase and sale agreement.

(It’s OK. We sign legally binding documents all the time. It you lease an apartment or a car, you have signed one.)

Will you have time to back out of the deal if you discover a problem?

Yes…up to a certain deadline. The due diligence period.

Never fear! I will walk you through the documents and the steps.

Let’s dig in.

The Letter of Intent: A Non-Binding Agreement

As with many real estate (and non-real estate) transactions, the process of buying a property from a seller usually includes two documents:

• Letter of intent: a non-binding agreement.

• Purchase & Sale Agreement: a binding agreement.

There are also a series of closing documents signed by each party just before closing, but these tend to be standard forms that are not as actively negotiated. Let’s not worry about the closing documents in this discussion.

So what is a letter of intent?

Think of the letter of intent (LOI) as a “handshake” agreement in 1-5+ pages. It will address the following:

• Property Description

• Names of Buyer and Seller

• Purchase Price

• Key Dates: due diligence start and end (aka the contingency period); closing date; extension options (if any)

• Deposit - typically around 3% of the purchase price (ex. 3% x $500,000 = $15,000)

• Name(s) of Broker(s) Involved

• Escrow and Title Company

• Confidentiality Requirement by Buyer and Seller

• That the LOI is Non-Binding: make sure you check that it is!

• Contingencies (if any): examples - loan assumption, tenant signing a lease, physical repairs

That’s about it.

It can be done in as little as one page.

Bigger firms may have more extensive LOI forms that include the list of due diligence items they require or other specifics, but the list above is the core of an LOI.

Most of the time lawyers are not involved as the buyer and seller, with the assistance of their brokers, prepare the LOIs.

The LOI goes back and forth between the buyer and the seller as the way to track the offer and counteroffers. This could happen one or many times.

Once the LOI is agreed to, the parties sign the LOI and move to the purchase and sale agreement.

Purchase and Sale Agreement: The Official Binding Agreement

The purchase and sale agreement (“PSA”) is both (a) much more extensive document than the LOI and (b) legally binding.

When you sign a LOI, you are putting your reputation on the line.

When you sign a PSA, you are putting your reputation AND your money on the line.

Even though most PSA’s give you a 15-30+ day due diligence period before your deposit goes non-refundable (i.e. you can’t get it back), you need to be very serious about buying the property if you sign a PSA.

You don’t want to build up a reputation as someone who signs a PSA but “can’t perform” - never actually buys (i.e closes on) a property. Brokers and sellers won’t take you seriously. The real estate community in most markets is surprisingly small.

So what’s in a PSA?

A PSA has all the components of an LOI plus (i) a more detailed description of the LOI terms, (ii) many additional terms and descriptions, and (iii) the PSA is binding.

Important Note: Refundable vs Non-Refundable

As we discuss the PSA agreement and the purchase process, let’s anchor in on the difference between the refundable (aka contingency) and non-refundable period.

• Refundable: From the date the PSA is signed (the “effective date”) through the expiration of the due diligence period, the buyer can typically back out of the deal for any or no reason and get their deposit back. No penalty. No foul. They still have to pay the consultants and advisors they may have hired and their reputation may suffer, but they don’t have to buy the property nor forfeit their deposit.

• Non-Refundable: Once the due diligence period expires, everything changes. The buyer can still back out of the deal, but doing so will mean they lose their deposit. Additionally, at this stage they are normally 15-30+ days into the process and emotionally invested in the deal. In my 20+ years of investing in real estate, I have seen less than a handful of cases where someone backs out of the deal after the due diligence period expires.

With that important foundation, let’s run through the additional terms and descriptions contained in a PSA that builds off the LOI.

Operating Conditions During the Purchase Process (aka Escrow)

The seller will continue to operate the property during escrow. Leases and contracts may be signed. Invoices will need to be paid. This section addresses how the buyer and seller will work together during escrow.

• Contracts & Leases: the buyer will often have rights to approve contracts and leases during the due diligence process. Once the buyer is non-refundable, they may have controlling rights.

• Leasing Costs: the buyer typically pays for commissions and tenant improvements from leases executed after the effective date.

Due Diligence

The buyer will want to review everything they can about the property before they put their deposit at risk by going non-refundable.

• Materials: list of materials the seller will supply to buyer. Typical materials include: (i) leases and contracts, (ii) historical income statements, (iii) list of vendors and utilities, (iv) warranties, (v) list of ongoing capital improvements, (vi) details on any outstanding insurance claims, property tax issues, municipal correspondence, and/or legal claims, (vii) seller disclosures of issues affecting the property, and (viii) any other items both parties agree upon.

• Inspections: the buyer will have the right to inspect the property, including with their consultants, in a non-invasive way. They will need to get explicit approval from the seller to be able to perform invasive testing.

Representations & Warranties

This is a fancy way of saying (a) what is each party saying is true <a “rep”> and (b) what will each party agree to do <a “warranty”>. They generally focus on the seller and include:

• Reps: the seller has the authority to sell the property. The seller is not bankrupt nor has any pending litigation. There are no tenants, leases, and contracts other than the ones provided in due diligence. The due diligence materials provided are true and correct.

• Warranties: the seller will maintain insurance. The seller will continue to operate the property in a professional manner leading up to closing.

Damage & Destruction, Condemnation

• Damage or Destruction: what happens in the event the premise is damaged or destroyed? The buyer may have the right to back out and keep their deposit if more than 5% of the property is destroyed.

• Condemnation: what happens in the event the premise is condemned? The buyer may have the right to back out and keep their deposit.

Closing Process

The PSA documents the details of the closing process including:

• Closing Conditions - Buyer: waived due diligence contingency; received title policy from title company.

• Closing Conditions - Seller: maintained reps and warranties; delivered required closing documents to escrow.

• Closing Costs: list of what buyer and seller will each pay. Seller typically pays the broker commission.

• Closing Steps: description of how the escrow company will handle the closing logistics.

Exhibits

Although PSA may be only 15+ pages, there could be 20+ pages of exhibits. These can include:

• Legal Description of the Property.

• List of Due Diligence Materials.

• Form of Deed: this is the legally recorded document that confirms the property has been sold.

• Form of Bill of Sale: this documents the sale of any personal property related to the physical property. Examples: parts and materials for repairing the property such as flooring or light bulbs.

• Form of General Assignment: this documents the transfer of the various contracts such as leases, warranties, and service contracts.

• Form of Estoppel: very briefly, an estoppel is a unilateral statement signed by the tenant for the benefit of a buyer and their lender confirming the key terms of a lease. Estoppels are common in larger commercial transactions.

• Any other specifics details relevant to the property such as the status of ongoing capital improvements.

At a Glance: LOI vs. PSA

• LOI

  • Legally Binding: no

  • Length: 1-5 pages

  • Purpose: handshake agreement before legal documentation

  • At Risk: reputation

  • Lawyer needed: no

• PSA

  • Legally Binding: yes

  • Length: 15-35+ pages

  • Purpose: legal contract

  • At Risk: reputation and money

  • Lawyer needed: if not using standard forms

How to Digest All of This

That was a lot to cover.

Some of you may be overwhelmed with the amount of detail and feel that it can’t be this complicated. Some of you may feel I am only scratching the surface.

You are both correct.

The level of complexity mainly depends on whether you a buying a 1-4 unit residential property or a commercial property (industrial, retail, office, or multifamily).

1-4 Unit Residential

If you buy a 1-4 unit residential property, whether for your personal residence or as an investment, you will likely use a templated agreement that is literally “fill in the blanks”. You won’t even use a letter of intent.

Everything will be done using the PSA offer and counter offer templates.

No lawyers. No negotiating items you are struggling to understand.

Some of you can breathe a sigh of relief.

Commercial Properties: Industrial, Retail, Office, Multifamily

For the rest of you, you will likely need to take the time to develop a basic understanding of what I described in the LOI and PSA documents.

For deals under $10 million, you may still use standard form PSA agreements like those created by AIR CRE. This is referred to as “using an AIR form”.

The benefit of this approach is that the buyer and seller are each agreeing to most of the items that get negotiated. They can focus their efforts on adding exhibits for items that either (i) fall outside the AIR form or (ii) they want to more actively negotiate.

This can be a great approach and one I support for smaller deals.

For those of you buying larger commercial deals and using customized PSAs, here’s my advice:

• Find a Good Lawyer: work with a lawyer who understand the issues that will come up AND is business minded - i.e. they want to figure out a reasonable solution to each item that is negotiated as opposed to proving how smart they are by over negotiating every item.

• Get Smart: spend the time needed to understand the issues from a business perspective as opposed to just relying on what the lawyer says. Think through what the issue really means. Ask your lawyer to explain issues in simple language and give you examples of real situations where this language would apply. As the buyer, you make the call on the final language. Not the lawyer. It is your money and reputation.

Red Flags to Watch For

While most sellers are honest, watch out for red flags such as:

• Seller resistant to reasonable contingencies > make sure you protect yourself.

• Significant items missing from due diligence materials > dig in to make sure the seller is not hiding something important.

• Seller rushing you through due diligence > take the time you need but understand that you can never make a “risk free” investment.

Trust your gut and don't proceed with the deal if it doesn’t feel right.

The Purchase Process in 5 Steps

The LOI and PSA are integral steps in the overall purchase process:

• Find property (last week’s newsletter)

• Submit and agree on a LOI (handshake agreement): 3-7 days

• Negotiate and sign a PSA (binding contract): 7-14+ days

• Complete the due diligence and go non-refundable (next week’s newsletter): 15-30 days

• Close: 15-30+ days

Yes it gets more complicated with additional investors and obtaining a loan, but this is the basic process. A fast process takes 30 days. A more typical process takes 45-90 days.

My Two Cents on How to Think About a PSA

I tend to find the heavy negotiation of PSAs to be overkill.

Why?

If there are issues that come up in the purchase process, reasonable buyers and sellers are normally motivated to work it out regardless of what the PSA says.

View the PSA as your purchase process handbook. It should guide you in the process.

But, remember that your most important asset is your word and your reputation.

Over negotiating the PSA as a way to plant trip wires to out maneuver your counterparty (whether buyer or seller) may help you on an individual deal, but will set you up for being known as a bad actor in the long run.

Be as good as your handshake.

Be a good person.

Life is better that way.

Professor Bateman

How To Find Your First Real Estate Deal: A Step-by-Step Guide

From online research to broker relationships—putting in the reps that lead to your first investment

We have covered a lot so far. Today we are going to dig into how to find your first deal. 

Before we do this, let’s do a quick recap of what we have covered:

• HOW to invest - REITs, LPs, self, with a partner, or as a GP: 5 Ways to Invest in Real Estate (From $60 to All-In)

• WHAT to invest in: Asset Classes Explained: Industrial, Office, Retail, Multifamily, and 1-4 Unit Residential

• TAX advantages: 5 Tax Advantages That Make Real Estate Investing So Powerful

• BUILDING A TEAM: You Don’t Have to Do Everything Yourself: Building Your Real Estate Team

• Finding your NICHE: Stop Chasing Every Deal: Why Successful Investors Pick a Niche

• Choosing your STRATEGY: The Risk-Return Spectrum: Choosing Your Real Estate Investment Strategy

• How to UNLOCK VALUE: Unlocking Value: What to Do After You’ve Improved Your Property

• The simple MATH of real estate: Cap Rates: The Simple Math of Real Estate Investing

Moving forward we are going to address the practical realities of:

• BUYING real estate investments: picking a market; working with a broker; analyzing deals; purchase and sale agreements; debt and equity; due diligence; and closing.

• OPERATING the property: value add initiatives; leasing; property management; construction; reporting; insurance; and property taxes.

• SELLING your property: working with a broker; preparing the property for sale; due diligence; purchase and sale agreements; debt and equity considerations; and closing.

Today marks the start of the series of several newsletters that will explain buying real estate investments.

Let’s dig in.

Understanding What You are Looking For

If you don’t know what you are looking for, you will be like a blind squirrel searching for a nut. You may find it eventually, but you will waste a lot of time in the process. 

A few weeks ago I discussed the importance of finding your niche and determining your investment strategy. Let’s build off these concepts and our previous examples. 

In the niche newsletter I created four examples of different combinations of asset class, geography, and strategy based on an investor’s time availability: 

1. No spare time: Retail - Tacoma, WA - Turnkey.

2. No spare time: 1-4 Unit Residential - Nashville, TN - Turnkey.

3. Some time to be more active: Industrial - San Antonio, TX - Light Rehab.

4. Time on evenings & weekends: 4 Unit Residential - Los Angeles, CA - Value Add.

Regardless of the asset class, geography, and strategy, the methodology is the same.

Getting in Your Reps

The first step is to start looking at deals. The great news is that you can do this after hours and on the weekend from the comfort of your own home.

How?

By using the power of the internet, your time, and (to quote the musical Hamilton) your “top-notch brain”!

There are many websites out there that list properties for sale: 

• LoopNet.com - best for commercial properties (industrial, retail, office, larger apartments/multifamily).

• Redfin.com or Zillow.com - best for 1-4 unit residential.

• Realtor.com - MLS-connected; comprehensive for residential.

Note that Redfin, Zillow, and Realtor will also be filled with properties for sales to homebuyers to live in. 

Pick one or two and set the filters to the parameters that fit your asset class and geography niche, as well as your price range. You won’t be able to filter by strategy (turnkey, light rehab, value add). To figure this part out, you will need to review the details of the property listings.

Step 1 - Go Down the Rabbit Hole

In your first pass, dedicate 1-2 hours to click around. Think of this like doom scrolling. You are reviewing the information in a general way to get a lay of the land.

Pay attention to how the assets (and the process) make you feel. Is there real interest in this niche? Do you get excited? Does this put you to sleep? 

Do you feel like you could come up with the equity (cash) to buy the property - assume you need 35% of the purchase price - example: $300,000 property x 35% = approximately $100,000 of equity.

If it puts you to sleep or is out of your price range, consider exploring another niche.

Don’t give up. Finding your niche is an interactive process that takes time.

Step 2 - Bring Some Structure

Now it is time to be more methodical by bringing structure to the process.

Get a pencil and a piece of paper (or open excel). Create a simple grid that lists the following details as columns for each property. Each property will be a row. 

• Address

• City or submarket

• Square feet or number of units*

• Asking (purchase) price

• Price per square foot or per unit*

• Rough calculation of annual net operating income (NOI, which equals revenue minus operating expenses). This should be on the listing or you can make an estimate.

• Cap rate: NOI divided by price.

*Use units for multifamily and 1-4 unit residential. Use square feet for retail, industrial, and office.

I did something similar for industrial properties in Escondido, CA on LoopNet last summer.

Example: My Escondido Industrial Property Search (Summer 2025)

What you are looking for is the properties that are a little better than the rest. In this case I was using cap rate (aka return on cost) as my main guide (column header is “Cap / ROC” in the table above.

Alternatively, I could have used price per square foot (“PSF” in the table above).

For each of the properties that had the higher cap rates (#s 6,9,10, and 11), I reviewed the materials on LoopNet in more detail and added some comments.

I didn’t like #10 and 11 because of some of the physical characteristics shown in red in my Comments column.

This left me to focus on #s 6 and 9.

The whole process took me a few hours.

Step 3 - Talk with Brokers

What?!?!

You mean I have to call someone I don’t know?!

Yes. You can do it. It is just another human being on the other end of phone.

To set you up for success, let’s breakdown the role of a broker.

In regards to looking at a property for sale, the broker that is listed on LoopNet or similar websites is hired by the seller to market the property for sale. The broker only gets paid (by the seller) if the property is sold. Said another way, they are spec’ing their time in hopes that they can successfully sell the property at a price that is acceptable to the seller.

Part of the role of a broker is to talk with prospective buyers about the property they are trying to sell.

They are working through the traditional sales funnel. 

1. They have to talk with many potential buyers. 

2. Some of those will turn into actual leads that spend time focusing on the property. 

3. A smaller amount will actually make offers. 

4. And one will (hopefully) be acceptable to the seller and buy the property.

So what does this mean for you?

If you call a broker and come across as being clueless and unorganized, the broker will see right through you and be unlikely to want to give you any time. A broker’s most precious resources are their time and reputation. 

Don’t waste their time. 

Be respectful. 

Brokers are an essential part of the real estate investing process. A good relationship with 1-3 good brokers may turn out to be the most critical part of your personal real estate team. They are the source of the majority of investing opportunities out there.

But what if you are just starting out? What is realistic for you? 

Here’s a script that I recommend:

You: Hello [broker’s name]. I am reaching out to learn more about [XYC property] I saw on [LoopNet]. I have spent the last X weeks researching properties like this in this market and this one stood out to me as one I want to learn more about.

Broker: Good to hear from you. Can you tell me about yourself before I walk you through the property? [Translation: are you someone I should spend my time on?]

You: Happy to. I am newer to real estate investing, but am ready to buy my first deal. I picked this market because XXX. I have the equity to buy a deal of this size (or have lined up investors). I have some ideas on putting a loan on the property, but would also welcome your perspective on loan options. I am looking to establish one or two key broker relationships with the goal of buying multiple properties over the next X years. What questions should I be asking about this property and the market?

—

What works about the script above?

1. You are being candid in the realities of being new.

2. You are showing that you have put in the time to focus on a niche.

3. You are making it clear that you have a path to getting the equity.

4. You are opening the door to a long-term relationship with this broker.

So what’s next?

Step 4 - Patience and Repetition

Now you need to keep doing steps 2 and 3 until you find a deal that works for you.

Expect to take 3-6+ months until you find a deal that works for you that you can get under contract. This includes:

• Building market knowledge (4-8 weeks).

• Establishing broker relationships (2-6 weeks).

• Finding and analyzing the right property (4-12 weeks).

Expect to review 20-100+ properties online and dive deep into 5-20 of these before you find the right deal for you.

New properties become available for sale all the time. Establish a routine where you check for new properties for sale every two days. 

By putting in your reps, you will start to better understand your niche and what works best for you. At some point you will see a property that checks all your boxes and is priced at a level that makes sense to you.

By then you will have talked with multiple brokers and seen many deals. Some of these brokers will even start sending you deals proactively, possibly even before they hit the market.

Important note on 1-4 unit residential deals: make sure you work with a broker that specializes in investment properties, not the homebuyer market. Investment brokers will understand how to analyze a property from an investment perspective.

You will have built a level of micro expertise in your market and established some small level of credibility with brokers in that market.

Most people have very little staying power. They try something and quickly give up.

Be the exception.

Pick a niche. 

Be respectful of brokers’ time. Leverage their market expertise.

Put in the time and focus to understand the market.

Before you know it, you will have found a deal that looks like it works for you.

So what do you do when this happens?

1. Call the broker immediately - good deals move fast.

2. Ask for the offering memorandum or marketing package that provides the details about the property.

3. Request a tour if you are local to the market (or even a video tour if you are not). 

We’ll cover the purchase process in detail next week.

Professor Bateman

Unlocking Value: What to Do After You’ve Improved Your Property

Cash flow, sale, or refinance—which monetization strategy fits your goals?

Let’s fast forward a bit and have some fun.

Imagine you have made your first investment. It has gone well.

You've done everything right—bought smart, improved the property, and now it's cash flowing.

Well done! 

Your hard work, patience, and perseverance have paid off. Maybe there was even a little luck along the way.

But here's the question most investors face next: how do you actually get your money out?

There are three main ways to do this:

1. Enjoy the cash flow.

2. Sell the property.

3. Cash out refinance.

Each way has its pros and cons. The decision of what to do depends on the goals you are trying to achieve, which may change over time.

Let’s dig in.

Your Real Estate Investment Example

Let’s create an example to use in explaining and evaluating the three ways to monetize your investment. The math will tie to my previous post: Cap Rates: The Simple Math of Real Estate Investing

Here’s the example:

A little over two years ago, you bought a property that was 100% leased to one tenant with two years left on the lease. The NOI at time of purchase was $10,000. 

You bought the property for $170,000 including your closing costs. After securing a $110,000 loan with a 5.5% interest rate, your equity was $60,000.

• $170,000 - $110,000 = $60,000

The property was old and in need of some cosmetic repairs. As it was fully leased when you bought it, you waited patiently until the lease expired to completed your light rehab.

You spent $30,000 to do a light rehab (paint, carpet) and paid a commission to a broker to find a new tenant. Because the loan amount is fixed, the $30,000 cost increased your equity (aka cash investment): $60,000 original equity + $30,000 light rehab and commissions = $90,000 total equity.

After the light rehab, you were able to increase the NOI to $15,000. 

Here’s a summary table to help you keep track of everything.

Real estate investment example cash flow

So what do these calculations tell us?

Cash Flow Increase

By spending a one-time cost of $30,000 for the light rehab and commissions, you went from $3,950 per year of cash flow to $8,950 per year. $30,000 to get $5,000 more per year? Well worth it.

NOI Increase = Value Increase

You have increased the NOI. NOI is a key metric buyers and lenders use to value a property. To oversimplify a bit, the value of the property has increased. 

Why is this oversimplifying? 

Because cap rates can go up and down depending on overall market sentiment, independent of your individual property. 

For this discussion, let’s assume they stayed fixed.

Monetizing Value

Now let’s get into the fun part. How do you turn our hard work into cash? Said another way, how do you “monetize” the increase in value?

There are three main ways to do this:

1. Enjoy the cash flow.

2. Sell the property.

3. Cash out refinance.

Each way has its pros and cons. The decision of what to do depends on the goals you are trying to achieve, which may change over time.

Monetizing Value: Enjoy the Cash Flow

The first way is the most straightforward and passive: do nothing and enjoy the increased cash flow. 

The $8,950 cash flow per year after light rehab on your $90,000 of equity is a 9.9% annual cash-on-cash return. Much of it is shielded from tax by depreciation. See 5 Tax Advantages That Make Real Estate Investing So Powerful. 

If you are a cash flow investor like I am, this may be the best fit for you.

Monetizing Value: Sell the Property

Properties are typically sold based on a capitalization rate (cap rate). In this case you bought the property for a 6.1% cap rate: $10,000 NOI divided by $165,000 purchase price = 6.1%.

Let’s assume you can sell the property for the same 6.1% cap rate. $15,000 post light rehab NOI divided by 6.1% = $245,902.

This gives you a profit before commissions, closing costs, and income tax of $45,902. $245,902 - $200,000 total costs. Not a bad return in two years for your equity investment of $90,000.

If you are focused on increasing your total net worth as much as possible, this could be the path for you. You could consider a 1031 exchange to defer the taxes as I discussed in 5 Tax Advantages That Make Real Estate Investing So Powerful.

Monetizing Value: Cash Out Refinance

Refinancing the property could be a way to have the best of both worlds. 

The increase in NOI will likely allow you to put a bigger loan on the property. Your original loan of $110,000 was approximately 65% of the purchase price. 

Using the same 65% on the new market value we calculated above ($245,902) would give you a new loan of just under $160,000. $245,902 x 65% = $159,836. This new loan amount is almost $50,000 more than your original loan.

Doing this is known as a “cash out refinance”. There is no tax on the $50,000. You could use it to invest in a new property.

Important Caveat: Not all lenders will immediately give you a cash out refinance. Every situation is different so talk with multiple lenders.

Remember than your interest costs will go up and your cash flow will go down. If we assume the same 5.5% interest rate, your annual cash flow drops from $8,950 to $6,209.

Refinance example

You also have higher fixed expenses with the new interest costs. This gives you less cushion if you lose the tenant and/or the economy gets bad.

A cash out refinance is a good option for investors who want the best of both worlds (and are comfortable with higher fixed expenses): ongoing cash flow and additional money to invest in the next deal.

Monetization Options: Sale vs Cash Out Refinance

In this example, the cash out refinance proceeds ($49,836) are more than the sales proceeds before closing costs and commissions ($45,902). 

This is not always the case. 

Interest rates and cap rates regularly move around depending on market conditions and market sentiment. If you are on the fence of which option is best for you, educate yourself by talking with brokers on market cap rates and lenders (or debt brokers) on loan options.

Monetization Options: Pros and Cons

So let’s put it all together to see what the best fit for you is.

Enjoy the Cash Flow

• Action: none; enjoy the additional cash flow.

• Pros: passive; no further execution risk.

• Cons: minimal current cash compared to a sale or cash out refinance.

• Good for: investors focused on cash flow.

Sell The Property

• Action: sell the property.

• Pros: ability to unlock value and 1031 exchange into a new property to repeat the process of a new strategy on a new property.

• Cons: execution risk on the sale; sale commission costs; tax exposure if no 1031 exchange.

• Good for: investors focused on creating maximum wealth by buying and adding value to multiple properties over time.

Cash Out Refinance

• Action: refinance the property with a larger loan.

• Pros: ability to unlock value without paying taxes and continue to benefit from (a reduced) cash flow; the proceeds from the cash out refinance could be used to buy a new property.

• Cons: execution risk on the refinance; transaction costs of refinance; risk of having more debt and interest expense.

• Good for: investors wanting to balance ongoing cash flow and ability to grow their real estate portfolio by buying new properties.

What Worked for Me

As with my investing strategy, my monetization strategy has changed over time.

Stage I (Years 1-10+): Buy > Add Value > Sell > Repeat

I was all about maximizing the power of the limited funds I had. The goal was to create value, sell a property, and invest it in a new one. This was an effective method to build wealth. I still have a number of investments that fit this strategy.

Stage II (Years 10+): Enjoy the Cash Flow & Cash Out Refinances

Once I had built wealth, or at least could see a path to that future with my existing investments, I started to be more focused on cash flow. I was able to build up a combination of assets under two strategies:

• Cash Flow: I have one property that I own debt free. The strategy is focused on consistent cash flow.

• Cash Out Refinance: Buy > Add Value > Cash Out Refinance > Repeat. The LP investments I have follow this strategy. I use the cash out refinances to buy more cash flowing assets. 

These stages have worked well together. I wouldn’t have been able to focus on cash flow investing without the capital I built up through selling properties.

Finding the Monetization Option That Fits You

Let’s think about what might work for you.

Situation A: Limited Capital, Long Time Horizon

This is likely your situation if you are early in your career. You are rich in time, energy, and health, but poor in money. You have a long time horizon for the power of compounding to go to work.

The buy, add value, sell, and repeat is a path that could allow you to turn your limited funds into something more meaningful.

Situation B: Some Capital, Shorter Time Horizon

Maybe you are exploring real estate investing for the first time later in life. Your time horizon to retirement, or at least leaving a W-2 job, is shorter. You have worked hard and saved a decent amount of capital to invest.

In this case a combination of enjoying the cash flow and cash out refinances may be a better fit for you.

What is Right for You?

I have seen investors follow each of these paths successfully. It all depends on your available capital, time horizon, and goals. 

Do you have an investing story that you are willing to share with me? Email me at bateman@creprofessor.org. I read every email and would like to hear from you.

Professor Bateman

The Risk-Return Spectrum: Choosing Your Real Estate Investment Strategy

From low-risk turnkey deals to high-return value-add and development—which fits you?

Here’s a question you may be asking yourself: ‘Should I buy a turnkey rental or fixer-upper?’ The answer depends on understanding risk versus return - and knowing where you sit in this spectrum.

Low Risk/Low Return ←――――――――――――→ High Risk/High Return

Last week we discussed the importance of picking a niche in terms of “how” (REIT, LP, solo, GP) and “what”. I introduced the three components of the “what”:

1. Asset Class: 1-4 unit residential, apartments, office, industrial, retail.

2. Geography: where you plan to invest.

3. Strategy: core/turnkey, light rehab, value add (or fix and flip), house hacking.

In today’s discussion, we are going to dive deeper into strategy.

Strategy will likely be the strongest dial you can control to determine the risk and reward that is right for you.

Risk and reward are generally inversely correlated. The more risk you take on, the higher the potential reward.

The key word here is “potential”.

Just because you have the potential to hit a home run, doesn’t mean you will. It often means you have a high chance of not hitting the home run - especially in your early days as an investor.

Successful investors have a clear understanding of risk vs. reward. The best ones pick a risk/reward niche to focus on so they can develop expertise in understanding and minimizing risk, all while trying to achieve above market returns.

Let’s dig in.

Five Strategies for Real Estate Investing

There are five strategies we will discuss today. Four apply to all asset classes. The last one only applies to 1-4 unit residential.

Low Risk/Low Return ←――――――――――――→ High Risk/High Return

Core/Turnkey → Light Rehab → Value Add → Development

1. Core/Turnkey: low risk, low return. You buy a property that is well leased and maintained. There is minimal work to do.

2. Light Rehab: medium risk, medium return. There is some work to do, but it is mainly cosmetic (paint, carpet, clean up). If you do the work, you can increase the rent and value of the property.

3. Value Add: high risk, high return. There is a lot of work to do. The property might even be vacant. You will be repositioning it and taking on a lot of risk for superior returns. You will either find a tenant once the work is complete or sell it (fix and flip).

4. Development: highest risk, highest return. You build something from scratch.

5. House Hacking: this option only applies to 1-4 residential. You will live in one unit (or room) of the property and rent out the other units (or rooms), allowing you to live rent free or at a reduced cost.

Each strategy has its own pros and cons. There is no right answer.

Choosing the right one for you depends on the time you have and your tolerance for risk.

Let’s discuss each one in more detail.

Core/Turnkey: Low Risk, Low Return

These type of deals require minimal work. They are fully leased and the physical building is in good condition. They are closest to stock market index fund investing in effort (low) and function similar to a bond, giving you consistent cash flow. Examples could include:

• A single tenant leased building built in the last 10 years and leased for 10+ years. This could be retail, industrial, or even office.

• A new four-plex in a strong housing market near a hospital or other major employer. Although the leases are not long, there is a major employer nearby who helps ensure all units will remain leased with little downtime between leases.

Core/Turnkey deals are great for investors that want steady cash flow and don’t have a lot of time.

Light Rehab: Medium Risk, Medium Return

Let’s continue up the risk/return spectrum to Light Rehab. There is some rehab to do, but it is fairly straightforward and mainly cosmetic (paint, carpet, clean up). It is the type of work that you could potentially do yourself on nights and weekends, or hire a handyman to do.

Essentially, you are freshening up the property and once complete, will enjoy some combination of higher rent, shorter time between leases, better credit tenants, or a combination of all three. Examples could include:

• A well built four-plex that is 30+ years old in a good market. The paint is peeling and the carpets are stained. Both are straightforward to fix. Buildings that look cleaner and more appealing are leasing for 10%+ more rent than the in place leases at this property.

• A single tenant industrial building that only has six months left on the lease. The existing tenant has been there for 10+ years, plans to vacate, and is leaving the space very dirty. Painting the walls, replacing the carpet in the office, and power washing the warehouse floors will make it look much better.

Light Rehab deals are good for investors that want to be a little more hands on in order to achieve better returns than core/turnkey. They are ok with some risk, but are not willing to spend too much additional money nor take on something too complicated.

Value Add: High Risk, High Return

Let’s continue up the risk/return spectrum. By buying a value add deal, you are signing up for a hands on investment. There will be a lot of work to do, including work that is not just cosmetic in nature. You may be redoing bathrooms or replacing roofs or even building out new rooms.

This is much more than a light freshen up. It will likely include hiring a general contractor and obtaining a building permit. All of this means more time and money.

In exchange, you will enjoy a meaningful increase (ex. 25%+) in the value of the property through a combination of higher rent, shorter time between leases, better credit tenants, or a combination of all three. Examples could include:

• A 40+ year old two story home in a zoning location that allows for up to four units. The investor will convert the property into a four plex. This will include adding three small kitchens and a new restroom, plus reconfiguring the property to create four individual private entrances.

• A 20+ year old retail property that had been leased to one tenant since it was built. The investor will convert it to a three tenant building by adding demising walls, bathrooms, and storefront entrances.

Value Add deals are good for investors that have a vision for what a property could be. They have time and money to do the work and are determined to maximize the value of their investments.

Development: Highest Risk, Highest Return

Developers are a breed of their own. They are like business entrepreneurs who create something out of nothing. Development is so complicated that I could (and may) dedicate an entire newsletter to it.

For now, let’s just say that it includes (i) buying the land with a vision for what could be built, (ii) creating an initial design and getting municipal approval to build it - the entitlements, (iii) spending time and money on construction drawings, (iv) going back to the municipality for a building permit, (v) hiring a general contractor to build the property, and (vi) leasing it. Examples could include:

• Buying vacant land and building a small industrial building.

• Tearing down an old house and building a new four-plex.

Development is a high risk process at each step. It is not for the faint of heart or inexperienced. Each step requires specialized knowledge: architecture, engineering, municipal approvals, construction management, and market analysis. Most developers spend years learning their craft before attempting their first project.

House Hacking: 1-4 Unit Residential Only

House hacking is a way to satisfy your own housing needs and be a real estate investor. You buy a property to live in that is bigger than you need and rent out the rest, allowing you to live rent free or at a reduced cost. Here are two examples:

• You buy a four-bedroom house with one kitchen and 3-4 bathrooms. You live in the master bedroom with a private bathroom and rent out the other rooms. You all share the living room, kitchen, and laundry room. Maybe you rent the rooms to friends as you will be sharing a lot of space together.

• You buy a duplex. You live in one unit and rent out the other. Your tenant lives in their own unit. There is no shared space.

House hacking is a creative way to become a real estate investor. Lenders view 1-4 unit residential as personal home loans, which can be easier to qualify for if you are a first time investor.

However, you have to be comfortable living with or near your tenants. This can get messy, especially if living with friends. Example: your buddy loses his job and can’t pay the rent. Are you willing to kick him out? Just plan ahead for what you are willing and not willing to do.

Understanding Strategy

Now that we have discussed five strategies, let’s break down the characteristics that (a) determine the risk associated with an investment and (b) determine your fit for each strategy.

Risk Associated with an Investment

To oversimplify, there are four main risks associated with a real estate investment:

1. Occupancy: is the property leased? How soon do the leases expire?

2. Rent vs Market: are the existing tenants paying market rent? Is there an opportunity to increase the rent? What are the current and anticipated market conditions?

3. Property Condition: is the property old? Is there deferred maintenance? Are the units leasable as is or do they need to be cleaned up first?

4. Property Function: is the property functional as configured? Do the number of units needed to be increased or decreased?

Let’s combine these with the first three strategies (excluding development and house hacking):

• Core/Turnkey: Low risk, Low return.

  • Occupied

  • Rent at or Near Market

  • Good Property Condition and Function

• Light Rehab: Medium Risk, Medium Return.

  • Vacant or Occupied Short Term

  • Rent Below Market

  • Property Condition Can Be Improved

  • Property Functional As Is

• Value Add: High Risk, High Return.

  • Vacant or Occupied Short Term

  • Rent Below Market

  • Property Condition and Property Function Can Be Improved

Your Fit for Each Strategy

Now let’s add in what is required for each relative to how it will impact you as an investor from a time and future dollar commitment standpoint.

• Core/Turnkey: Low risk, Low return.

  • Most passive; minimal time commitment and ongoing capital investment.

• Light Rehab: Medium Risk, Medium Return.

  • Active for focused periods of time; more passive after rehab; requires some investment of dollars and time after purchase.

• Value Add: High Risk, High Return.

  • Very active for focused, extended periods of time; may be more passive after rehab; requires significant investment of dollars and time after purchase.

• Development: Highest Risk, Highest Return.

  • Significantly time consuming for 2-3+ years; requires coordinating the efforts of many consultants and specialists; material capital commitment years before completion.

Very Important Side Note: Strategy is only one element of a real estate investment. The market you invest in will play a HUGE role in the success of the deal. Spend the time to research and understand the market before you make your first investment. Talk with brokers. Read research papers. Understand the major employers and drivers of the local economy.

My Strategy Evolution

Here’s how it evolved for me over the past 23 years of investing.

• Stage I - Clueless to Strategy: I made an LP investment in a value add hotel deal. I had no idea there were different types of strategy or that I was taking on more risk than I realized. I was lucky it worked out.

• Stage II - Value Add with Employer: I spent most of my career with a GP focused on value add industrial. By joining an established firm with leaders who understood value add investing, I was able to get paid to learn. When I made personal investments, it was mainly alongside seasoned investors who had “been there, done that”.

• Stage III - Value Add as LP: In 2015, I started making LP investments with a multifamily GP focused on value add deals. I even spent two years working for the GP and learned the operational side of the multifamily business. Their leadership team had years of value add investing experience. They were able to minimize risk through their extensive track record.

Finding the Strategy That Fits You

So which is right for you?

If you are new to real estate investing, you don’t know what you don’t know.

Something that may look risk-free to you could be riskier than you think. Something that looks risky to you, could appear much less risky to a seasoned investor.

Unless you can work for an experienced GP and invest alongside them, I recommend starting simple with a core/turnkey or light rehab.

Get a few deals under your belt.

Make some mistakes and learn from them before you buy a value add deal.

Here’s a quick self-assessment guide. Ask yourself:

• Time: Do I have time on evenings/weekends for 3-6 months?

  • If not, then consider a Core/Turnkey deal.

• Capital: Can I set aside cash reserves for cost overruns and unexpected issues?

  • If not, then consider a Core/Turnkey or Light Rehab deal.

• Experience: Have I completed 2+ deals through stabilization and/or sale?

  • If not, then consider starting with a Core/Turnkey or Light Rehab deal.

• Tolerance: Can I sleep at night with a property that is filled with uncertainty?

  • If not, avoid Value Add and Development.

Be honest with yourself. Miscalculating risk and how you will handle it can turn your side hustle into a 20-40 hour per week commitment.

Investing takes time and patience.

You can always become a value add investor later down the road. Just recognize that you need to put in your reps with simpler deals first.

Learn the fundamentals of operating real estate: market analysis, the acquisition process, securing a loan, executing a business plan, property management, tenant relations, and property accounting.

Doing this on a simple, low-risk deal really has its benefit.

There are no shortcuts.

You have to put in the work.

Professor Bateman