Paying Contractors

We have paint and texture on all drywall at Blue Ridge, but we seem to have lost a week in the process somewhere.

This post originally appeared on the Hermit Haus Redevelopment website on 2016-01-23.

The Blue Ridge project is taking longer than expected. Don’t they all? But the texture is on the walls and painting has commenced.

As best I can tell, we are about a week behind schedule without having encountered any serious delays, just a series of small ones. But, as with pennies, small delays add up.

This situation is an example of why you should pay your contractors on completion of tasks, not on a time-based schedule—no matter how good they are or how much you trust them. Unfortunately, we agreed to weekly payments on this project, mainly because we had too much going on, had our primary contractor back out of bidding because of too much work already booked, and urgent relief at having found a recommended GC who was willing to start two weeks earlier than anyone else. Not to mention the distractions of the Christmas season.

All of that now leaves us in a situation where we have to renegotiate the payment schedule at the end of the project.

When you pay on task completion, you risk having your project become a lower priority than “more lucrative” projects. On the other hand, paying on completion guarantees you won’t be paying for undone work, but it doesnt guarantee timely completion. Either way, delays increase your holding costs during a project.

Here are some lessons we’ve learned over time:

• Have your contract written so you pay on completion of a task rather than on a schedule.
• If the contractor is furnishing the materials, keep the upfront payments minimal, but reasonable.
• Keep tabs on the work as it progresses, and don’t be shy about asking questions.
• Always plan on paying at least 10% more than the bid. There will always be things you didn’t know about when the project went out for bid.
• Plan for at least six weeks of holding costs beyond the scope of the project. There are almost always delays in the renovation and sale processes.
• If you plan for a longer, more expensive project, you’re in good shape if it comes in on time and on schedule. The inverse is not true.

 

Construction Update: The Value of a Dumpster

The nanny suite has been skinned with hardiplank, but its emerging beauty is hidden by debris. Thanks to the dumpster, Blue Ridge looks inviting, even in the middle of the renovation.

This post originally appeared on the Hermit Haus Redevelopment website on 2016-01-18.

This post started out to be a quick update on the two renovation projects we currently have running, but you know me: I can’t resist wagging my tongue when something finally sinks in. So, I’m going to preach (probably to the choir) about dumpsters first, and give a short update at the end.

Many rehabbers use dumpsters at their projects—certainly all of the ones you see on television. But others let the refuse pile up or pile it onto trailers to take to the dump when they are ready. The GC I have used for the last eight years falls into the later camp. “Why pay the money for a dumpster when I can haul stuff away much cheaper?” he asked the first time I suggested getting one. Not being intimate with that part of the business, his logic swayed me. He is handling the Villa Park project.

We decided to use a dumpster at the Blue Ridge project as we brought on a new GC who actually preferred renting a dumpster. The photos at the right show the difference between the two projects, both run by professional contractors who are very good at what they do.

I won’t compare overall costs, because the two projects are radically different and have produce dramatically differing qualities of debris. But priced by the yard, the dumpster method seems to win out, even in cost. Thirty yards of debris cost roughly $500 to dispose of at Blue Ridge. The same amount of debris cost about $450 to dispose of at Villa Park. So I saved $50 by having my GC haul off the waste. But take another look at the two pictures.

Now here are some hidden costs of having your GC dispose of the construction debris:

Lost work

Your crews aren’t making progress on your project when they are at the dump.

Neighborhood respect

While I haven’t received a single complaint about the debris at Villa Park, I haven’t had a single neighbor inquire about what we do and if we can help them. We have had a stream of neighbors at Blue Ridge wanting to see the project, and several talked about friends whom we might be able to help.

Workplace safety and productivity.

None of the crew on any of my projects has ever reported an injury. That said, I can’t help but believe piles of trash around a project have to decrease productivity as workers carefully negotiate the paths they have left.

Pride

While I am proud of the work we’re doing at both projects, and I know I will be extremely proud of the final products, I am ashamed of going to the Villa Park project now that I have seen a well maintained workplace at Blue Ridge. I believe the workplace conditions will also affect the pride of craftsmanship in the workers, too.

I am now an advocate. We are ordering dumpsters for the Villa Park project, and I have made a convincing economic argument to that contractor in favor of them.

Villa Park Update

We have now passed all inspections and are moving forward with finishing out the walls. The skylight has been removed and roofed over. It wasn’t leaking, but they eventually do.

Blue Ridge Update

All walls inside the house have been refloated after removing the popcorn. We lost a day because someone turned off the heat, and the drywall compound didn’t dry overnight. We should be ready to paint early next week, and the flooring will go in shortly thereafter.

Streams of Income from Rental Properties: Equity Growth—Infinity and Beyond

Buzz Lightyear should be every real estate investor’s hero. He had the right motto.

This post originally appeared on the Hermit Haus Redevelopment website on 2016-01-19.

So far, we’ve talked about the most obvious stream of rental income (cash flow) and the less obvious concept of viewing depreciation as income through tax reduction. Today, I want to talk about equity growth.

As you continue to make monthly mortgage payments, your equity in the property grows. But remember, you are not making the payments. Your renter is. So that equity growth represents a very real increase in your wealth, and you don’t have to do anything to get it except keep your rental property in rentable condition and rented.

Before we get started today, I want to be clear that I am making some unreasonable assumptions in this discussion. I make these assumptions because I want to talk about making money on borrowed money, and clouding that concept with other issues makes that concept much more difficult to understand. We’ve all been taught for years that debt is bad, but Robert Kiyosaki points out that there is good debt and bad debt. I’m talking about good debt. So here are my assumptions:

You are only breaking even every year for the duration of a thirty year mortgage.

Chances are you’ll make more than enough money to cover all of the expenses of owning a rental property and put money in your pocket besides. So for the purposes of this discussion of good debt, we’ll assume you neither make nor lose money but that your cash flow remains completely neutral with regard to your mortgage payment.

Your rental stays occupied 100% of the time.

This is the only assumption I believe is totally bogus. You will have downtime in your rental income stream. But over time, your cash flow from the property should be more than sufficient to cover all the payments.

There is no such thing as inflation.

As you’ll see in the next post in this series, inflation will ensure you make more money the longer you hold the house, even if you start out with negative cash flow. But for this discussion, your rental will neither depreciate nor appreciate. Taxes and insurance will remain as fixed as your interest rate, and along with maintenance, they will be irrelevant. Another way to visualize this assumption is to think of all your maintenance costs being wrapped into your mortgage payment.

So here’s the deal:

Even if you only break even on your monthly payments, your rental property will increase your wealth from day one.

The chart says it all. The golden bars are the balance you owe on the rental. It goes down over time. The blue bars represent your equity in the house, and it goes up as your tenants make your payments. The green line is your return on the $25,000 cash you invested to buy the rental.

That increase in wealth only becomes taxable when you sell. If you die, your heirs’ basis is the value of the property at the time of your death, so the increase essentially is invisible from a tax perspective—assuming your estate is worth less than about $5.4-million today, or whatever the threshold for the estate tax is at that distant point in the future. Even then, the value of the estate is taxed, not the value of the individual properties that comprise it.

That’s right. If you later refinance the rental to get your $25,000 investment out of it, your tenants continue to make your payments and you have an infinite return on investment. If you refinance enough out of this property to pocket your $25,000 (but why would you) and buy another rental, you’ve essentially doubled your infinite return. You’ve done what Buzz Lightyear only talked about; you gone to “Infinity and Beyond!”

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Posts in this series:

1. Streams of Income from Rental Properties
2. The Two Examples and Cash Flow
3. Tax Reduction Through Depreciation
4. Equity Growth

Good Company

This isn’t a very good picture, but it shows the boys in one of their favorite office activities: pretending to be cats sitting in a window.

I spend a lot of time working in my “office,” which is really a room in the garage I originally intended to use as a woodshop. Brody and Harvey keep me company even though I’m sure they’re bored. They still like hanging out with me.

We Learned Stuff

Even though the slide I’m looking at is nearly blank, I did take good notes throughout the weekend. Photo by: Sue Ann

Sue Ann has her own comments on this seminar on the Hermit Haus Redevelopment website today.

As a long-time instructional designer in the corporate world, I appreciate good training. But the truth is, you can even learn something for poorly-designed training. This weekend seminar on marketing strategies wasn’t the best designed training I’ve ever seen, but it did have lots of good information. A passionate trainer helped.

My big take-aways include:

• Marketing takes time to be effective. Keep throwing good money after…it.
• While most mail campaigns can start to familiarize recipients with the sending business after four or five contacts, marketing to a probate list can take more than nine or ten contacts.
• People will respond more favorably to mail marketing from a female name than a male one. Really?
• The presenter has had good results from outbound calling. Again, really?
• “But what about the dog?”

 

Streams of Income from Rental Properties Part 3: Tax Reduction Through Depreciation

Try to think of depreciation on rental properties as an income stream instead of as your money going up in smoke.

This post originally appeared on the Hermit Haus Redevelopment website on 2016-01-08.

This is the third of the articles I’m writing on the financial advantages of owning rental properties. A couple of recent posts have pointed out some of the hazards of owning rentals, and everything said in those posts is true. Owning rental properties is a business, and there are risks in any business. If you don’t manage your properties well, you could lose money. Let me restate that. If you don’t manage your properties well, you will lose money, sleep, and peace of mind—the last being the most important.

That said, the US tax code is written to encourage people to invest in real estate, from individuals who own only one home to investors who own many. It contains so many tax benefits for rental owners, you’d need to be a real estate tax specialist to understand all of them. And if you’re playing this game, you definitely need a good CPA and a good lawyer. I have them, and so does every professional investor I know. Further, I’m not going to pretend to be an expert in tax law or strategies. I’m writing these articles from my own experience, and your experience will definitely be different. You’ll do somethings better than I did, and you’ll do somethings worse. You’ll make or lose more money that I did, and I’ve done both.

Depreciation

So lets talk about depreciation. As an investor in rental properties, you are required to depreciate the improvements on your rental properties—just the buildings, not the land. For the sake of argument, let’s assume depreciation on the example house worked out to $5,000 per year. It doesn’t, but that’s an easy number to work with. At this rate, you will have written off your initial $25,000 investment in five years.

In the negative cash flow situation, there would be probably little or no impact to your annual taxes, but the depreciation and other loses would affect the bottom line when you sell. This minimal impact is because most of us can only use real estate losses to shelter real estate income, and conservative accountants will only allow you to carry forward the loss to shelter next year’s income, if any. The IRS publishes guidelines for being certified as a Real Estate Professional, which changes the rules substantially, but I’m not qualified to publish anything that might be considered tax advice; so I won’t. Talk to your CPA.

In the positive cash flow scenario, depreciation would more than offset the $4,800 dollars the rental put in your pocket. If you’re in the 40% tax bracket, that would be the equivalent of reducing your tax burden by $1,920—a return of almost 8% on your initial $25K investment.

The Downside to Depreciation

The downside to depreciation is that it reduces your basis in the property. Basis is basically what you paid for the property plus any improvements that are not deductible as expenses. When you sell a property, you subtract the basis from the sales price to calculate your profit on the property for tax purposes. When you sell the property for more than your basis, you have to recapture the amounts you depreciated as income on the sale. But that comes much, much later—if ever.

My mom, a Realtor^®, used to joke that cemetery plots were good investments. “People are just dying to get in there.” Photo by:

If you leave the property to your heirs, their new basis is the value of the property at the time of inheritance; all of your deductions for depreciation don’t count after you die. If the property is worth $200,000 when you die, the new basis for your heirs is $200,000. That makes depreciate an almost infinite return on investment, but it doesn’t help you when you’re dead.

There are also tax advantages associated with equity growth, but that’s the subject of the another article in this series.

Are you starting to get excited about owning rental properties? Writing this series of articles has reinvigorated me, and helped reshape my investment strategy. As my friend and mentor Phill Grove says, “How many rent houses should you buy? All of them!” Just make sure you buy them right, and they’ll make money for you.

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Posts in this series:

1. Streams of Income from Rental Properties
2. The Two Examples and Cash Flow
3. Tax Reduction Through Depreciation
4. Equity Growth

Blue Ridge Demo Day

Blue Ridge during demolition. Compare this to the photo of the Villa Park nanny suite below.

This post originally appeared on the Hermit Haus Redevelopment website on 2016-01-03.

It’s unusual that you can say that a house looks better right after you start demolition. The demolition process usually piles trash throughout the house and around it, making it look trashy or even scary. But as you can tell from the picture, the Blue Ridge house is an exception to that rule.

The first thing we did was to take out all of the excess shrubbery behind which the house originally hid. That opened up the front of the house and made it much more inviting. Unfortunately, it also emphasized the damage that is been done to the front arch.

Carol, Sue Ann, and I had previously agreed that we would take down the arches on either side of the kitchen to get the house and more modern look. I think that plan is working, even with the pile of rubble piled to either side of the kitchen.

The interior of the house is pretty much as described in the opening paragraph—trashy. The kitchen and both bathrooms have been gutted to enable a clean, 21st century renovation. The ancient carpets have been removed, and the faux beams have been taken down from the ceilings. All of that debris is stacked in various places around the house awaiting delivery of a dumpster that has been promised by noon Monday.

It’s Not Always a Nail

If all you have is a hammer, pretty soon everything starts to look like a nail.

This post originally appeared on the Hermit Haus Redevelopment website on 2015-12-31.

This post is my take on the situation that spawned Sue Ann’s post yesterday. We came across a prime example of a deal that is not a good deal for everyone, but we were still able to find a good solution for a distressed seller.

Carol knows a frustrated landowner whose last tenants left his house unlivable when he was forced to evict them. He wants out of the renting business but is willing to owner finance the house.

There is a reason it’s called “property management.” Despite my series of posts extolling the benefits of rental ownership, renting houses is a business. It’s risky, and it’s not for everyone.

Russell, Carol, Sue Ann, and I all evaluated the house to determine what we would be willing to pay for it. At the same time, the owner asked Carol to show the house to another investor who had approached him. Sounds weird, huh? We’re looking to buy a house, and the owner asks us to show the house to a competitor. And we did so without hesitation. Carol is a Realtor®, so that gives us one more tool to help distressed owners find an acceptable solution. So, no problem.

It turns out that the other investor was willing to pay slightly more for the house than Hermit Haus was, because he focuses on that particular part of town. But he still wasn’t willing to pay what the owner wanted for the house. The owner didn’t see either our offer or the slightly higher offer from the other investor as beneficial enough for him at the time.

So what is the best win-win solution?

This trashy image from HuffPo symbolizes the house we evaluated. It isn’t that the problems were so bad, just that there were so many of them.

Let’s step back and look at the house. It’s a four bedroom 2.5 bathroom brick two story with a two-car garage. After renovation, it will be a perfect home for a growing family. Unfortunately, there is that thing about the house not being livable right now. That means a family will have trouble finding a bank willing to finance the house in its current state. But that’s okay because the owner doesn’t want to sell the house outright; he wants to finance it. We can also help the right buyer find funding to rehab the house and increase their equity in it—kinda like what they do on Fixer Upper, but we don’t to the rehab. Luckily, we can put the right buyer in touch with the right contractors, as well as the money to fix it up.

In investor language, that’s called having “multiple exit strategies.” In Hermit Haus terms, it’s called “having the right tools to find the right solution for the problem.” The old saying is holds that if you only have a hammer, everything starts to look like a nail. At Hermit Haus Redevelopment, we pride ourselves on being able to look at the actual situation and find the right solution, not just the one that fits the tool at hand. Depending on the situation, we will take one of six positive actions to help any distressed owner:

• Buy the house ourselves and renovate it to sell
• Buy the house and renovate it to as a long-term hold (rental)
• Wholesale the house to another investor
• Refer the house to Carol to list as a Realtor^®
• Advise the seller on other methods of getting out from under the property
• Walk away from the house and nothing but good wishes for the seller

In this case, our solution was for Carol to list the property as an owner-financed fixer upper. When she finds the right buyer, we will have a good set of solutions for them, too.