APPLYING RULE #1 TO REAL ESTATE

Ever wondered if the 4M's of Rule #1 investing can be applied to making real estate decisions? Here's your answer:

Phil,

I would like your opinion on other forms of investing.  For example, I currently have an option to buy a mobile home park.  It is a relatively small one, with 18 hookups.  There are currently 12 trailers on it and they are individually owned.  The current owner of the land gets $200/month/lot for lot rent.  So, he is currently grossing $2,400/month.  His only expenses are: $300/month taxes, and $1,000/month water bill.  When he owned all the trailers and had the park full, he was supposedly netting about $4,000/month.  He will sell it to me for about $1,200/month.

The total selling cost would be about $200,000, but he would finance it for me and my monthly payment would be about $1,200/month.  Now, my wife's grandparents would love to have a place to live at no expense and take care of the property and collect the rent.  I think my time in the property would be minimal.  I'm just trying to decide if it is really wise to get into.  I know you are normally into stocks but I thought I would check with you on this one as well.  I really appreciate any feedback you can give me.

S.G. 

Here's what I told him:

I like any good Rule #1 investment.  Publicly traded businesses, private businesses, apartments, farms and trailer parks are all good for the Rule #1 investor because we treat them all exactly the same. So let's do a Rule #1 analysis on this trailer park.

First M is Meaning:  Do you get what this trailer park offers as a business?  It sure ain't hard to figure that one out when houses cost $500,000 and up.  A clean, dry and inexpensive place to live.  Just make sure you know what the real expenses are and what the real rents are.  Take into account some maintenance expenses like broken water lines and cracked cement.  And know if the rents are high or low and can be raised, or were they just raised to look good to a buyer?

Second M is Moat:  Is this trailer park durable?  Will the business be around in 20 years?  The average boomer is 50.  In twenty year the middle of the boomer generation will be 70 and by all accounts does not have the money for retirement.  Think they might downsize into well-run, safe trailer parks?  So what about competition springing up all over the place?  After all, one trailer park might be a lot like the next, so you might want to look at that aspect.  How are you going to compete if developers put in a big beautiful trailer park village nearby?  Or will that just increase the value of your place?  Might not be much moat here except price... which might be all you need.

Third M is Management:  Which is you and your family.  If you think you can handle it, that's the easiest management team to trust in the world.  But as you will see below, running one of these to get a margin of safety is going to be hands on.

Fourth M is Margin of Safety:  I love to get a margin of safety in a real estate deal.  I once bought farms from an oil company because they didn't want to run the farm but they did want the oil rights.  They got the oil rights, my partners and I got thousands of acres of producing trees and vines for the price of the dirt.  And a tax shelter.  Big MOS.  So let's look here:  You're just putting in the difference between what you collect and the $14,400 a year you owe the seller. Figure $5000 a year from you. So you have to get your EPS up to $15,000 to break even.

So how much will you be able to raise rents each year?  Can you raise the rents faster than the county is going to raise the taxes and the water bill?  Let's say you can and rents go up with no vacancies ever at 4% a year over your cost increases.  That means that in ten years your EPS is $15,000.

So after ten years of feeding this investment you finally break even and sell it for the same cap rate you bought it at, 5%, for $300,000.  So to know how well you might do, how much did you put in?  I ran a little analysis on it for fun.  The first year you get $10,000 but owe $15,000 (roughly).  That's $5000 you have to put in.  The second year because you raised rents a bit you only put in $4600... and so on until the tenth year when you just put in $700.

I ran what's called an Internal Rate of Return which gives you your rate of return calculating for the fact that you didn't put all your money in there at once but rather spread it out over ten years.  Your rate of return if you sell this thing for $300,000 and pay off the $200,000 loan is 18% compounded.  Pretty decent and above our 15% requirement for a Minimum Acceptable Rate of Return.

Of course we have no margin of safety, which ain't the way we do things round here.  So we gotta get one in this deal somehow, because 4% rent increases might not keep up with taxes, or real estate could go flat if interest rates skyrocket.  So here are a couple of MOS possibilities:

1. You buy trailers cheap, one at a time, that are run down but solid.  You get your grandmother to put in new curtains and your grandfather to put in new carpet (just kidding.  You do it).  You clean up the rust, put on a nice apron and some stairs and a colorful awning and now you're creating a margin of safety.  Let's say it costs you $3000 to fix up a trailer and $10,000 to buy it used.  You rent it for $650 a month, $7000 a year net.  It's paid for in two years.  From then on you get paid well for your trouble.  $4500 a year for the trailer, $2500 a year for the pad.  So your $13,000 investment returns about 35% a year.  And you are building margin of safety.
2. In five years when interest rates are 8%, the seller may want to get cashed out of a 6% interest rate if he thinks rates are going to continue to climb.  You could offer to buy back the $200,000 note at a discount that reflects the new rates.  In this case he might take $150,000.  Instant margin of safety.

Rule #1 is about investing.  In anything.  Apply it and prosper.

Now go play.

Phil