Saturday, September 26, 2009

Operating principles

If you are a first timer, please read the following pieces first. It will provide you with important background information.
1. Why I created this blog?
2. How am I going to operate this blog?

I have been contemplating on real estate investments for some time. I am not handy. If I want to do real estate without being ripped off by a contractor, I have to found some partners who are handy. It is really hard to find the right partner. The following is the operating principles I wrote for some potential partners. If you know a lot about how to fix houses and agree with my principles, email me and we may be partners.

1. Cost Control

Operating a business is simple but not easy. We want to increase revenue while lowering cost. However, growing revenue is a trial and error process. We are going to try many things but not knowing which one will produce the results we have wished. Cost control is usually more predicable. If we can reduce labor and use a less expensive brand of tools, we know what the saving will be. Buying, fixing and renting houses is a simple business. We will compete with numerous experienced veterans and a lot of would be investors. Being the lowest cost producer will give us competitive advantage helping us grow our business. Our goal should be to use the most durable, easy to install, simple material and process to fix houses.

2. Leverage

Leverage is risky. It runs two risks: default risk and interest risk. But in real estate, we have to use leverage to produce acceptable returns due to its inherent nature: heavy initial investment and low yield. We should use non-recourse and fixed rate financing whenever possible. We will use government subsidized financing whenever possible. And we don't overgrow ourselves. If we are wrong, we only lose what we can afford to lose. For example, if we have $1m funding (our equity and borrowings), we should not do over 4 projects at the same time (if each projects costs $150K).

3. Commitment

Building a business needs commitment. No matter what kind of equity we put in, sweat or monetary capital, it takes time before the investments yield satisfactory returns. We also need to prepare for drawbacks due to happen and build enough reserves to seize opportunities when they present themselves. Before we can enjoy the fruit of our investments, we must retain our earning for the minimum of three years. There are going to be clauses in our bylaws to ensure the commitment to the business, the company and our partners.

4. Cash flow

We are going to focus on cash flow. We are a small operation with limited resources. To ensure the viability of the business, we must only do deals with safe positive cash flow from the very beginning. Bigger companies sometimes do long term project without positive cash flow for the first several years and reap the handsome return later. We don't have that luxury. Some smart firms have one subsidiary produce positive cash flow to support long term strategic investments in another subsidiary. When we become bigger, we may do something like that. But for now, we must focus on the projects which can produce positive cash flow in the first 6 months.

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