When 15% ROI Is Not Enough for Real Estate Investors

Investing in distressed real estate offers extraordinary opportunities

Investing in distressed real estate reshapes traditional ways of looking at what we expect in terms of investment yields, “cash-on-cash” returns or Cash Flow. In today’s terms, “distressed” refers to properties being sold by foreclosing banks at deep discounts. Herein lies the opportunity: Whatever we choose to call the results of this continuing bank sell-off of foreclosed multi-unit buildings, today's situation offers extraordinary opportunities for “entrepreneurial” investors.

Rethinking real estate ROI potential in today's market

We used to look at real estate investment returns of 10, 15 or even 20% on our “equity”, the amount of cash required to purchase an investment property. This is the "spendable cash" available after all operating expenses are met, including reserve accounts, and the debt service (mortgage) was paid.

And in neighborhoods already recovered from the recent correction, these are the returns one might expect if they were to buy-in today. Percentage returns (ROI) will, of course, vary depending on how highly leveraged the investment may be, and diminish over time as equity increases and tax benefits decline.

Smaller rental properties don't "fit the model"

Smaller rental properties are an excellent entry to real estate investing. But, for a variety of reasons, they must be measured by their own standard.  The financial returns realized with smaller “stand alone” 2- and 3-flat residential properties seldom perform as well when compared with larger multi-unit properties; particularly once  maintenance, reserves and vacancy and credit losses are taken into account. Doesn’t mean they are bad deals. They just cannot meet the norms of true investment property analysis (applicable to 6-units and greater).

Such smaller properties are more appropriate for the owner-occupant who will live on site–or at least nearby–and perform the necessary maintenance and management responsibilities himself. The prospect of “free rent” on the owner’s apartment is often the primary reward, even if not really free at all: that apartment is costing the equivalent of the monthly rent. But of course there’s more– It is, after all, "the tenants who are retiring the mortgage(!)". Certainly this is an “investment program”, but rather labor intensive when compared with our preferred model of real estate investing in larger properties.

When it comes to ROI, it's about 'doing the math'

The picture changes considerably when buying “distressed” multifamily properties. It is just a matter of doing the math. When a rental property–6 units or more–is acquired initially at a discount, and the work required to restore cash flow is reflected as well in the purchase price, the investor will always be investing considerably less (per unit) than had he purchased an intact property with a stable income stream. That’s his incentive for going to the trouble of “doing distressed”.

And the rewards are substantial. It is not unusual to find the investment return to be double the ten or fifteen percent ordinarily realized. Think of it this way: if the first-year cash return is, say 30%, then the investor’s initial capital investment (equity) is returned in full in just over three years.

Entrepreneurship applied to real estate investing

The returns available to the Entrepreneurial Investor, the investor who seeks out the unique situation, the undervalued asset, and works a “turn around”, will be rewarded. Initially it is more a matter of entrepreneurship, of being willing to step in where others perceive undue risk and simply “fix the problem”. In retaining the property for subsequent cash flow and appreciation the "investor role" takes over.

By virtue of uncommon skill, foresight and nerve, the entrepreneur will always advance faster, and perhaps further, than the more traditionally conservative investor. Combine the roles of Entrepreneur and Investor and enjoy the rewards of both relatively quick profit and the investor’s long term growth in wealth. #.

- Philip Elmes