Risks and rewards of the industry

Aliza had always known her father worked in business, but never understood exactly what he did. When he passed away and she took over as executor of the estate, she did a search of his assets and was shocked to find 800 properties, albeit most of them worthless, which he’d supposedly bought in anticipation of the area becoming popular overnight. She had little in the way of records and no bookkeeping files. While the easiest thing to do would have been to sell all the properties as a package deal to the highest bidder, Aliza decided to figure out which of the properties were profitable and to only sell the rest.

While Aliza is hard-pressed to see the glamor in real estate (“it’s just another job”), many others strike gold (or, at least, copper) in real estate investment. Let’s look at the different types of real estate investing, what the experiences of the investors were like, as well as their tricks of the trade.

Just Call Me Landlord

Though Hershel from Cleveland, Ohio considers himself a newcomer to real estate investing, his portfolio says otherwise. He started off buying an inexpensive home in Far Rockaway, New York. With experience in construction, he was able to fix it up himself, raising its value. Next he refinanced, and was able to withdraw equity from his house in the form of cash. Then he used the cash from his refinance to buy another property that had just hit the market.

Now Hershel was at a crossroads. He consulted with his rav, who advised him to take advantage of opportunities that would present themselves. Ultimately, he decided to focus on properties in lower-income neighborhoods that came with guaranteed rent from tenants, in the form of Section 8 vouchers. (Housing Choice Voucher Program, also known as Section 8, is the federal government’s program for assisting low-income families, the disabled, and the elderly afford housing.) Hershel is careful to treat his tenants like he would want to be treated. “This is even more important since most of my tenants are not Jewish, but know I’m an Orthodox Jew,” he says.

Business took off, and before long, he had properties in Alabama, upstate New York, and Ohio. “Diversification in investing is important, but in real estate, it can hurt you,” says Hershel. He was spread too thin. At this point, he decided to consolidate his portfolio and look into hiring a management company. “I heard management companies weren’t a good idea, but I found a great company to work with. This allowed me to still keep real estate as a passive income. Yes, there are extra expenses when you hire a management company, but it freed up my time to do more.”

Management companies take on the burden of collecting rent, making repairs (sometimes at a cheaper price than if you were to find them yourself), and acting as the go-between between landlord and tenant. Initially, Hershel stayed on top of the management team. With time, the two parties got used to each other, and mutual trust followed.

In contrast, when Aliza stepped in after her father’s passing, she discovered that her father’s management team was downright crooked.

“They would make fake bills for renovations of properties that turned out to be boarded up,” Aliza recounts. The rule she made for herself is to only retain properties no more than three hours away. “The people who work for you should be scared that you’re going to check up on them at any time. My dad never checked up. It’s nice to trust people who work for you, but people make bad decisions.”

Buying & Selling REITs

Let’s say you like the idea of investing in real estate, but you don’t have (or want to throw) large sums of money into deals or properties. Consider REITs. REITs, or real estate investment trusts, are companies that own or finance income-producing real estate across a range of industry sectors, including retail (shopping centers), industrial (warehouses and distribution centers), offices (skyscrapers and office parks), residential, and health care, among others. There are publicly traded REITs (e.g., that trade on the stock market) and private ones. Some examples of publicly traded REITs include American Tower Corporation (ticker: AMT) which owns and operates cell phone towers, Simon Property Group (ticker: SPG) which is the largest owner of shopping malls, and Americold (ticker: COLD) which owns cold storage warehouses (its customers include Kraft Heinz and Walmart).

REITs can be further divided among equity REITs and mortgage REITs. Equity REITs invest in properties and earn income from rent, property sales, and dividends. Mortgage REITs invest in mortgages and mortgage-backed securities (a type of asset that is secured by a mortgage or a collection of mortgages). These types of trusts can earn income through the interest collected on mortgages (though keep in mind that interest rate changes can greatly affect their return). Lastly, hybrid REITs invest in a combination of mortgages and real estate.

REITs offer a number of benefits to investors. Like stocks, publicly traded REITs trade on major stock exchanges and can be bought and sold instantaneously so your money isn’t locked up (unlike owning actual properties or investing in deals). Further, REITs are required to distribute at least 90 percent of their taxable income to shareholders annually. This makes REIT dividends quite substantial (higher yield than bonds at times).

But REIT investors also have to face the risks. While some argue that REITs tend to have a low correlation with other assets, (which can help investors reduce the risk in their portfolio), investors should still expect the price of a REIT to fluctuate, including dipping when the stock market drops. In other words, when the S&P 500 zigs, don’t expect your REIT to necessarily zag.

While REITs might seem more simple than buying an actual building, a proper analysis of a REIT requires a bit of legwork. First of all, REITs are sector-specific. For example, Simon Property Group owns malls and other retail-specific properties. When the pandemic hit in early 2020, malls suffered along with the retail sector. So when you’re checking out REITs, dive deeper and analyze the industries that the properties intersect with.

Further, REITs aren’t just impacted by real estate trends. They’re often affected by market and economic forces, such as changes in interest rates, inflation, and government policy changes.

Understanding Investment

There are two main strategies when it comes to property investment: focus on the cash flow from the rent, or buy properties in the hope they will appreciate over time. While some investors get lucky with a sorely undervalued property, oftentimes it’s very hard to time the market and predict trends correctly. While Hershel prefers to “buy and hold” his properties, he sees the benefit of balancing both strategies, especially when it comes to the tax benefits. With a background in accounting as well, he understands the tax implications of buying properties that appreciate in value versus those that provide rental income.

“When there’s high cash flow from the rental income, I’ll have to pay higher income tax,” he says. “Yet when I have appreciating properties, I have losses from depreciation on paper, and these two can balance each other out.” Ultimately, having an accountant to weigh in on investment decisions can be extremely helpful, if not vital.

While Hershel only sees his real estate investments as passive income at this point, he does try to target a 15% to 20% “cash on cash” return. This means that if he puts $100,000 into a property, he’s hoping to get between $15,000 and $20,000 in rental income each year (as a frame of reference, the S&P 500 has an annualized rate of 10.5% for the past 50 years).

Hershel won’t divulge the secret to how he finds his properties, but he will say that he uses MLS listings such as Zillow to find them, trying to narrow in on sellers that have multiple properties they’re trying to sell as a package. Since the seller wants to offload the package to just one person, as opposed to dealing with multiple buyers, he’s more likely to net the deal.

While he finds it profitable from a business perspective, he shares his altruistic motivation as well. “If you can control a few blocks, you can help raise the standards and change an area for the better.”

For some investors, passive real estate can morph from the occasional headache to full-blown nightmares. Rachel from Baltimore and her family are in the hard money loan business. A client of theirs used the money to buy a property in Newburgh, New York. When the borrower couldn’t repay the loan, he asked if he could just give them the property in exchange for forgiving his loan. They agreed, figuring they’d just renovate the house and eventually sell it. But soon after the closing, Rachel found out that the amount of unpaid taxes for the property equaled the value of the property! Then things went from bad to worse.

“We got a call from the church across the street,” she says. “They were calling to complain about the house we had just bought. Let’s just say we wish we never had our name attached to that property.”

Rachel and her family were left with no choice but to cut their losses and simply donate the property to the church. They lost their investment, but they ended the nightmare.

“The lesson we took from this is that you really have to know what you’re getting yourself into,” she says.

The Art of a Deal

The idea of owning property might sound appealing, but the logistics can be daunting. This has led many “average Joe” investors to partner up with real estate professionals who find the properties, buy them, and then share the wealth.

So what’s so great about these types of deals? High returns. The structure of such deals is usually based on how long the properties will be held, and can differ in complexity. For example, sometimes an investor receives a yearly return such as 7% to 8% on his investment. Investors can also see cash on top of their annual returns from the sharing of refinances, sales, or cash flow (in the form of “splits” with the investment firm).

It’s hard to predict which deals that investment firms do will go sour and which will strike it rich. A real estate investor from Lakewood, New Jersey, says he’s done multiple deals with the same real estate investment firm — one deal hasn’t yet earned him a penny, while another netted him 150% within two years!

River Rock Capital, a real estate investment firm based in the Five Towns, specializes in acquiring and managing multifamily properties (ranging from six-unit buildings to 700-unit complexes), primarily in New Jersey and Texas. A few years back, a broker had brought them an off-market building in Jersey City. Forty-eight hours after the closing, the same broker called up and asked if they would sell the property! Taken aback, they asked how much the buyer had in mind. Six weeks later, the building was sold, and investors received two and a half times their initial investment back.

But let’s say our Average Joe wants to DIY-it and find these deals himself. Unfortunately for him, investment firms like River Rock Capital have a leg up. In real estate, it’s all about reputation and trust. Brokers and sellers prefer to deal with buyers who have a solid history for making the deal go seamlessly and quickly.

Found It, Flipped It

While not technically considered investing, “flipping” properties is another way to make money off of real estate. Flipping houses involves buying a property, renovating it, and selling it for more than what it was originally bought for. While it’s not always a given that the property can be sold for more, those in the business are willing to take the gamble.

Shaya Samet from Far Rockaway, New York, finds the easiest way to find such a deal is for a broker to introduce him to a property that’s undervalued.

“You can see the house, analyze how much work the house needs, and then based on the work needed and the comparable homes in the area, you can see what your profit margin will be,” he says.

While Samet started off by hiring a contractor to renovate the property, he soon got to the point that he could have his own construction crew. It lowers costs and is more efficient, but means he needs at least seven to ten such deals yearly to keep the crew busy.

But waiting for brokers to approach you with deals may not always be a lucrative approach, as some brokers have learned to hold the best deals for themselves or direct these deals to someone they’re connected to. Other ways to get “flippable” properties is through short sales and bank foreclosures. A short sale is when the owner of the property owes more on the mortgage than what the property is worth, while a foreclosure is when the lender (bank) seizes the property when the homeowner can no longer meet the financial obligations of the mortgage.

Banks aren’t necessarily in the business of holding properties, especially since these properties cost money (snow removal, taxes, and other preservation needs), so banks are motivated to get rid of them. However, these sales can take months, sometimes years. While properties like these can yield great deals, it can take a lot of time and patience.

Another caveat: Flipping a house can cost real money. If you don’t have the cash to cough up to buy the property, you may need to resort to hard money loans that can be around 12% in interest. If the project takes longer than expected, you’re paying interest on your loan for longer, and losing out on your hard-earned profit.

The Risk Factor

Is a deal like this for you? First of all, there’s no such thing as return with no risk. While many other industries, like the stock market, are highly regulated, the real estate industry isn’t. Just because a real estate professional may portray a deal as a slam dunk, it isn’t necessarily so. Numbers can be inflated (e.g., potential rental income or assumed appreciation of the property) and deflated (e.g., expenses of the property), and the broker may not be up front about all the terms.

Aliza considered investing some of the cash she’d made from a property sale into a deal. However, upon reading the fine print, she became uncomfortable with the line about having to guarantee the loan from the bank. Ugh, she thought to herself, no way, no how. She considered hiring a lawyer to look over the contract, but the expense just didn’t seem to make sense when calculating what her assumed return would be. Ultimately, she decided the risk was too high and walked away from the deal.

There are other factors beyond our control that can impact real estate investment; take Covid as an example. Real estate investors with portfolios that included retail stores were affected, as well as buildings that had tenants who were there due to work. When they lost their jobs or switched to remote work, they left, and the property’s rental income suffered. Further, certain locations were affected by an eviction moratorium, which meant landlords couldn’t evict an unpaying tenant.

The Big Fish

While some like to dabble in real estate, others, with a knack for the numbers and a relatively large appetite for risk, dive in all the way. With good mazel, they can make a comfortable living from building up and maintaining a large real estate portfolio. Take Chaim, a real estate investor in Florida. One of his first deals involved a massive retail strip center that a broker told him about. The broker’s uncle owned the property and was looking to sell it. Chaim liked the location and went into contract for the property for $30 million.

Soon enough, he realized things weren’t aboveboard. “I realized the guy was lying about the financials,” he says. “I pulled out of the deal and also realized that there was no way the guy was paying the mortgage based on the current financials.”

Being a savvy businessman, Chaim called up the bank and said he was interested in the property. While nothing came of the phone call, a year later, Chaim got a call from a bank representative. The property was now in default and the bank asked if he was still interested in buying the property.

The location was great but the property was really run-down. Chaim did his due diligence and determined that the default was due to mismanagement and overleverage (the property owner had borrowed too much and was unable to pay the loan premiums). Ultimately, Chaim bought the property for $21 million, and brought a few other investors into the deal. They financed $15 million of the purchase price, and refinanced about 18 months later, recouping their initial equity. Eight years have passed and the property is worth close to $60 million.

With the money from this initial deal, Chaim looked for more deals. “Typically, I don’t syndicate out to a million people. I have a few partners and we’ve built up a lot of trust in each other.”  With a full bank account, Chaim ventured on numerous deals, some more complex than others. After many years in the business he’s learned to pass on the smaller stuff. “I’d rather make 10% on a $20 million property than 40% on a $200,000 property.”

“I purchased an office building in West Palm Beach for $3.5 million,” he says. “Prior to my purchasing the building, the seller had signed a lease with up a government tenant for a large space in a mostly vacant building. The tenant had a list of renovations that were supposed to be made before the move-in date but these renovations didn’t happen. When I bought the building, I was hoping to renegotiate with the tenant and get an extension on the tenant’s buildout plan. Surprisingly, the government declined my request for an extension and signed another lease down the street. This was a huge blow. If the government had moved in, it would have effectively raised the [building’s] value from $3.5 million to $7 million.”

Chaim decided to fight and ended up in litigation with the government. He argued that they had no clear right to terminate the lease. They offered him $700,000 to settle, but he declined. While Chaim ended up losing the lawsuit, he was able to sell the building for $4 million, recouping his initial investment and money spent on legal fees, and he doesn’t regret it.

“If it happened again today, I would still buy the property,” he says. “The risk wasn’t that great, but the reward would have doubled my money in a short amount of time.”

With the surge in Florida’s popularity, we ask Chaim what he thinks will happen now to Florida’s real estate market. “There are thousands moving here and everything is exploding,” he says. “On the one hand, the market has a bubble kind of feeling — you can ask whatever you want for your property and it will sell. But on the flip side, it seems like the higher prices are justified by the amount of people moving here. It’s no longer a vacation spot. There are real industries here.”

Ultimately, Chaim doesn’t know what will happen in the future and if a market correction is in the cards . He believes mazal plays a significant role in success in real estate. The timing has to be right, but timing anything is difficult. “Nobody can honestly say for sure that something is going to be a slam dunk. There are too many variables,” he says.

Short-Term Renting

Avi and Nechama always wanted a second house near the beach, and while vacationing at a certain West Coast beach town, they came across a house for sale. They ran the numbers and realized they could swing it. After buying it, they decided to offer the house to short-term renters, and covered their mortgage payments like that.

While it’s no simple task to let strangers stay on your property, with the right precautions and doing your research ahead of time, the rental money can be a nice complement to your regular income.

Leverage Smartly

If you’ve ever purchased a house, chances are you know what leverage means, even if you’ve never heard the word before. When you “leverage” a property, it means that you borrow funds in order to purchase a property instead of having to pay the entire price yourself (e.g., a mortgage). Being able to leverage is one of the main reasons that real estate investing is so attractive.

Let’s say there’s a property worth $1 million. You put down $250,000 and borrow $750,000 from a bank. Rent from the property (after paying expenses) is $90,000. You have to pay $59,000 in annual loan payments. $90,000 minus $59,000 is $31,000 (the amount in cash you make each year from the property). The return on your cash investment is 12.4%.

But now let’s say you pay fully in cash and don’t use leverage. This pushes down your return to 9% per year ($90,000 income on $1 million).

While leveraging sounds great, it’s risky business. If you can’t pay your loan to the bank, the bank may be able to foreclose on your property and you can lose your investment. Further, if your property value falls, you may end up with a loan that’s more than the entire value of the property. If you have a short loan period, you may not be able to refinance the property or sell it before the loan is paid off.

Chaim warns about the pitfalls of overleveraging. Assume you buy a property for $1 million. You get a loan for 75% or even 80% of the value of the property. If you’re paying $60,000 on the mortgage and you lose a tenant, or something unexpected like Covid hits, you may end up with mortgage payments that are higher than the income from the property. You can easily end up in a situation where you can’t cover your mortgage or your mortgage payments are eating up too much of your cash flow.

“In speculative markets, there’s a lot of overleveraging,” he says. “Sure you can buy more real estate if you’re overleveraged, but if the market turns around, you’re going to be in trouble.”

Work the Numbers

A big advantage of investing in real estate is the tax benefits. Considered a bona fide business, real estate investing allows you to take tax deductions. Paying interest on the loan? Making repairs? New software? Travel expenses? These are expenses and can be considered deductions. (Make sure you always ask your accountant first!)

Then there’s depreciation. While you can’t write off the entire purchase of residential property right away, you can write it off over 27.5 years. Is your property leveraged? You still get to depreciate the total cost of the property, not just the cash you put into it.

Ultimately, having income from rent means income taxes, but balancing it with an appreciating property that you’re depreciating over time can allow you to offset your income. However, keep in mind that as you depreciate your property, you’re also lowering your cost basis. This means higher capital gains when you sell. Next stop, 1031 exchange!

(Originally featured in Mishpacha, Issue 901)