What is your time worth? Time is the most precious resource we own. If you want to invest in real estate to own and operate, then you must decide what your time is worth. Real estate can be very time consuming. Therefore, you must make sure your returns are attractive enough for the time you put into each project. A common trap you must avoid is a Zombie Asset. Zombie Assets take up the same amount of time as any other investment, but produce much worse cash flow.
What is a Zombie Asset?
A Zombie Asset is primarily an asset that is purchased for a very low cap rate and financed using a loan. For example, if we were to purchase a property in Beverly Hills, then we would be buying the asset for about a 5% cap rate. Unless you are an all cash buyer of the building you must leverage the building. In today’s 2012 marketplace, if you are a savvy investor, then you can probably get financing for about 4% interest only for 7 years, amortized over 30 years. For arguments sake, let’s assume the loan to value of the purchase price is 75%.
This creates an unfavorable financing scenario. This 4% interest rate creates a loan constant of 5.729%. Therefore, the effective rate for the loan, 5.729%, is greater than the cap rate, 5%. The building’s income cannot outperform, let alone keep up with cost of capital. For this reason Zombies can be stressful.
Why some investors like Zombies?
Many investors hold fast to the risky idea of “location, location, location”. Yes risky, that was not a typo. Many people will purchase properties in prime locations. The downfall of prime locations is mediocre cap rates. These investors hope that within two to three years the building will appreciate a sufficient amount in order to cover the loan payments. Many investors found out the hard way when they purchased real estate in 2005 and 2006. In this recessionary period there were very few rent increases. In addition, many properties’ rents decreased. Their assets did not appreciate and their bank was not thankful.
Why Zombies are bad?
In essence, you are operating the building not for the benefit of your bottom line, but for the bank’s bottom line. Over 75% of your time spent managing this building is being depleted treading water to make sure you can keep up with the loan payments. Hence, you are “working for the bank” and not for yourself. In these uncertain times, why would anyone want to own an investment for the tradeoff of short term burden in exchange for a hope of long term benefit?
Better Investment Options
An investor that buys a building with a high cap rate turns the financial dynamic. For example, if an investor purchases a property for a 9% cap rate, then they would be outperforming the interest rate of 4%. This is significant because the investor makes a spread of 5% on the entire loan amount. This provides a foundation for purchasing a building and maintaining positive cash flow.
One uncontrollable risk factor most investors face is rising interest rates. If interest rates rise and rent does not increase, then the value of the building decreases. For example, consider a situation where interest rates rise from 4% to 6%. An investor who owns real estate in a 5% cap rate area just experienced a negative shift in the value of their building. Essentially, their asset became a Zombie Asset. Therefore, it is very important to purchase property at a high cap rate in order to maintain a cushion from rising interest rates.
Finally, I have never heard of an asset that was cash flow positive and the bank foreclosed on it. Cash flow should be the highest priority investment criteria, not location.