John T. Reed's analysis of Dolf de Roos' book
Real Estate Riches

Around 1980, Dutch Boy Paint Company—another organization that is biased in favor of paint—ran an ad showing a house before and after it was painted “inside and out with quality Dutch Boy paint.” The house appeared to be a perfect candidate for a paint job, as you would expect Dutch Boy to choose. The ad claimed that the average appraised value went from $75,400 before painting to $86,100 after “according to three professional appraisers.” They did not say how much the paint job cost. But even Dutch Boy did not claim the $20,000 increase de Roos says you can get with a $400 exterior-only paint job.

My wife and I had our house built in 1983—around the time of the Dutch Boy ad. The total cost of the interior and exterior painting and staining was $10,900. Our house is 3,360 square feet. The house in the Dutch Boy ad appeared to be about 1,500 square feet, so it would probably have cost at least $5,000 to paint inside and out. Painting an existing house is more expensive than painting a brand new one.

90%-of-value financing on million dollar properties other than single-family, owner-occupied homes is also extremely rare, although if you could prove to the lender that you were buying at 33% below market value, your chances of getting such financing would increase. See my book How to Buy Real Estate for Little or No Money Down.

De Roos does not state the time period during which the property doubled in value. Typically in the post-WW II era, that has taken a decade or more.

Refinancing a $3 million rental property to a 90% loan-to-value ratio may never have been done in the history of the world. About the only way it would be possible is if there were some high-credit personal guarantee from an extremely wealthy landlord or a high-credit tenant, like the U.S. Postal Service, on a long-term lease.

The “surplus cash” is loan proceeds. He means you just borrowed $1.8 million more than you needed. I hope you had a good reason. It’s just a loan that has to be paid off with interest. It’s not a winning lottery ticket.

He also fails to note an issue called “excess loans over basis.” When you refinance, you generally have a higher mortgage balance than your depreciation basis in the property. This would be absolutely true if you mortgaged out more than $1.8 million above the property cost. If you sell, and the buyer takes over your mortgage, or you abandon the property, it is considered the same as selling it for the loan balance in the eyes of the tax law (assuming the lender can’t or won’t come after you for the full loan balance). That would give you an enormous phantom (taxable gain, but no cash sales proceeds) gain (loan balance minus depreciation basis). The tax on such a gain is due within 90 days of the end of your ownership. See my book Aggressive Tax Avoidance for Real Estate Investors for an accurate account of these issues.

There are two intellectually honest ways to debate: facts and logic. As you will note, my criticism of Kiyosaki, de Roos, and others provides just that.

There are a number of intellectually dishonest ways to debate, like changing the subject or meaningless slogans. This is an example of another one of them: name calling.

Lawyers say, “If the facts are on your side, pound on the facts. If the law is on your side, pound on the law. If neither is on your side, pound on the table.” In this paragraph, de Roos is pounding on the table in anticipation of the pounding on the facts and the law that he knew I would eventually deliver regarding his book.

Where did the “throwing in a weekend of labor” come from? Page 10 only referred to a “$400 paint job.” Sounds like he’s already backing away from that claim after only five pages. At that rate, his $20,000 increase in property value will require $400 worth of paint brushes by the end of the book.

The typical operating expense ratio in residential rental properties is 45%, plus or minus about 2%. This is well established by hundreds of surveys by the Institute of Real Estate Management, the National Apartment Association, and other organizations. 45% of $20,000 is $9,000. That means the net operating income is $20,000 - $9,000 = $11,000. The average capitalization rate in a Seattle survey was 7.8%. That’s probably normal for the U.S. in general. If the cap rate is 7.8%, the purchase price of the property is $11,000 ÷ 7.8% = $141,026.

De Roos advocates 90% loans. 90% of $141,026 = $126,923. At current 7.5% interest rates, the mortgage payments on that $126,923 mortgage would be $881.95 per month or $10,583.42 a year. So the mortgage plus operating expenses number that de Roos says is $15,000 is, in the real world, $19,583.42. That means the $5,000 profit de Roos says you will get is, in fact, $20,000 - $19,583.42 = $416.58.

Note that these numbers apply to apartment buildings. Single-family rental houses, which are about all you could get for $141,000, would have much worse numbers. On a rental house with $20,000 annual income, you would typically have negative cash flow of several thousand dollars.

What’s the title of this book again? “Real Estate Riches” That apparently refers to what happens to de Roos when you buy it, not what happens to you when you apply it.

The mortgage would be 90% x $200,000 = $180,000 and the annual payments on a 7.5% mortgage that big would be $15,009. So your before-tax cash flow would be $20,000 - $9,000 operating expenses - $15,009 mortgage payments = minus $4,009! Your before tax cash-on-cash return would be -$4,009 ÷ $20,000 (down payment) = minus 20% not plus 25%.

What would the depreciation deduction be? Let’s say the land value is $25,000 leaving $200,000 - $25,000 = $175,000 for the structure, which is the only part that can be depreciated. For residential property, you can depreciate 3.64% in most years. 3.64% x $175,000 = $6,370, not $9,000. Even if you could somehow claim that you had no land at all and depreciate the whole $200,000, you could never deduct $9,000 depreciation in one year on a $200,000 property.

My book Aggressive Tax Avoidance for Real Estate Investors recommends a couple of ways to get the deduction a bit higher than that in the first five to fifteen years, but I doubt even those techniques could get you to $9,000 on this property.

De Roos tries to prove real estate is better by showing average stock prices and average home prices. One big flaw in that is you can buy the average stock by investing in an index fund. But you cannot buy the average U.S. home. You can only buy 123 Elm Street or 562 El Cerrito Boulevard or some other unique property. The stock index fund will perform the same as the stock market if you buy a marketwide index fund. But the performance of any unique parcel of real estate you buy will likely deviate significantly from the U.S. national average home price.

The most powerful earthquake ever to hit the U.S. was centered in New Madrid, MO on December 16, 1811. Charleston, SC had a powerful earthquake in 1886 and Anchorage, AK in 1964. There was an earthquake in the Philadelphia area when I lived there. Boston had a bad quake in the 18th century. New York City’s invulnerability to earthquake loss would come as news to the New York City Area Consortium for Earthquake Loss Mitigation. Here’s a line from one of their reports:

“However unrecognized or unacknowledged the threat from earthquakes may be in New York City, seismic events have occurred and, until recently, no codes have existed to mandate earthquake strengthening of structures.”

There is a report at http://nycem.org/techdocs/EstEQlossNYC/EstEQlossNYC.pdf that shows, on its page 176, a color-coded map of the earthquake resistance soil quality in Manhattan. It has no Class A (best) soil and much class D (second worst). In other words, de Roos pulled his “most stable land on the planet” comment out of thin air.

San Francisco has more frequent earthquakes than East Coast cities, but earthquakes in the West that would have a 50-mile damage radius would have a 500-mile damage radius in the east because of the different geology in each area. If you have to own a building in an earthquake, you would prefer it to be in San Francisco where they know earthquakes and have numerous laws regarding structure strength and location, water cisterns for fire fighting, numerous earthquake drills, and so forth. In the East, they are extremely complacent about earthquake risk and therefore woefully unprepared.

But the main point here for readers of de Roos’ book is that the guy is spouting off about an important and even dangerous subject without doing any homework.

De Roos reminds me of what Winston Churchill once said about one of his enemies: “He knows many facts which are not true.”

Nothing Down author Robert Allen hired a property manager and told him “I don’t want to hear from you until the end of the year”—the sort of three-hours-per-property per year involvement that de Roos claims. At the end of the year, the property manager reported to Allen that all his properties had an average vacancy rate of 60% for the year, which, of course, means they lost gobs of money. Allen sued him, which probably took more than three hours per property.

There is no free lunch. In addition to the fact that operating a rental business profitably is very hard, owning rental property is a large responsibility. You have tenants, employees, equipment, and structures to take care of. Landlords get sued. I shudder at the thought of an attorney representing one of de Roos’ injured tenants, visitors, or employees making him read this three-hours-a-year line and his bragging about how rich he is, from his book, to the jury at a negligence trial. When I got sued once by a tenant, her attorney tried to depict me as an uncaring absentee landlord. They had me read to the court a line from my book about investing in real estate to get rich. Unlike de Roos, my book had no bragging about how little time I spent on each property. I was able to disprove the uncaring absentee landlord accusation by showing detailed logs of my at least weekly calls to the on-site managers. If de Roos really owns properties on more than one continent and really only devotes three hours max per year to each property, and he gets sued for negligence, he is toast.

The legal doctrine of substance over form says that what you put in a contract will often be ignored by the law. For example, most single family lease options would arguably be treated as land contract sales in a court because of this doctrine. Persons buying homes being foreclosed in CA must be very careful what clauses they put in and which they leave out. All contracts, to be enforceable, must have legal purpose. Many things that you might put in a contract would make its purpose illegal, thereby rendering it unenforceable and possibly providing evidence for a criminal conspiracy charge.

If there is any seller financing in the deal—and de Roos is a big advocate of seller financing—the words “or nominee” would arguably render the contract unenforceable on the grounds that there could not have been a meeting of the minds because no seller in his right mind would agree to make a huge mortgage loan to “anyone of de Roos’s choosing.” People only make mortgage loans to those whose credit they have checked.

This and the item above are so-called “weasel clauses.” They exist only in seminars and books by gurus who target novices. In the real world, contingency clauses must be specific so the seller can still force the buyer to close if the contingency is satisfied.

My mom bought her home for $12,000 in 1963 and we sold it for about $80,000 in 1993. The Census Bureau says the average one-family house sold for $21,500 in 1965 and $149,800 in 1990. That is somewhat misleading because homes have gotten bigger and have more bathrooms, central-air, and so forth since 1965. The home that existed in 1960 would not have grown in value to $149,800 in 1990 because it probably only had one bath, no central-air, etc.

The main point is de Roos shows a value growing $250,000 ÷ $4,000 = 62.5 times in his example, whereas various real world stats indicate values growing only around 6 times during that period. This is a specific example of how he makes it sound far easier—ten times easier in this example—than it really is to make money in real estate.

In reality, property managers almost universally neglect properties and take kickbacks from suppliers and subcontractors who overcharge the client in order to cover the kickbacks.

You should either manage your properties yourself or hire salaried employees to do it. Most large companies that own income properties around the U.S. use local suppliers and subcontractors for everything except property management. They have found from hard experience that quality property management is not a service you can hire from independent companies. For example, Consolidated Capital used to be one of the biggest owners of apartments in the U.S. They used local carpet installers, plumbers, and so forth, but they had to form their own in-house property management company—Johnstown Properties. A major pension fund told me they had to form their own in-house property management company to manage their office buildings nationwide. Some cynics think companies who form in-house property management companies do so to get more fees. Not in that case. There is little or no profit in property management. Many real estate brokerages do property management as a loss leader just to get the listing on the property when it is sold. Landlords would prefer to avoid in-house property managers for the same reason they avoid in-house plumbers, carpet installers, and so forth. However, they have found they cannot avoid managing their own properties.

Do not, under any circumstances, hire an independent property manager to manage your properties. The notion that you can hire out property management is a myth promulgated by real estate investment information salesmen (and independent property managers).

The basic idea in civil law is that you may contract for a penalty that reflects the actual damage done to you by the lateness. That typically would include an initial minimum charge for the administrative hassle triggered by any lateness, plus interest at a reasonable rate. You cannot do what do Roos said earlier in the book: put anything you want into a contract. Not only would the lease be rendered unenforceable by such a clause, you would almost certainly be penalized for charging a usurious interest rate.

The main reason the mass market gurus push nothing down is to overcome the objection “I don’t have any cash to invest” when they try to peddle their expensive “boot camps” or “mentoring” services. Gurus do not push nothing down because it makes sense for an investor. Rather they push it because it helps them market their products and services.

Many successful investors always put 100% down, like those who buy foreclosure auction properties. Investors who specialize in property wanted ads always advertise fast cash. It is much more time consuming to do nothing down deals, so it is mainly a strategy for those whose time has very little value. If you always put little or no money down, you would be forced into a few niches where you would wander the land as a sort of beggar pleading with sellers to deed you their property for nothing. I offer a book on How to Buy Real Estate for Little or No Money Down, but I said in that book that it often is a bad idea—that you would be better off in most cases spending the extra time working a second job and saving money for a down payment instead.

Flippers, for example, sell all the time by definition. Builders always sell, and many of them drive real nice cars. Almost all the profit in real estate comes from selling; hardly any from operating rentals. To never sell is to consign yourself to a lifetime of marginally profitable property management.

Even if you adopt a long-term holding strategy, there are times when you need to sell. For example, if the neighborhood where one of your properties is turns bad, you need to get out.

How often you sell depends on your investment strategy. For some strategies, you would rarely sell; for others, you would always sell. You should not restrict yourself to only those strategies where you rarely sell. Pick the one that best fits you.

I used to be an agent. Agents have a duty to qualify prospective buyers. That is, they must find out how much they have to put down and what their income is so as to avoid wasting time showing property to persons who have no hope of buying it. At the lastest, the agent and seller must make sure the buyer has enough cash and income to close before they sign a contract and take the property off the market.