Leverage

Leverage

Leverage can be a scary word, especially post-recession.  For many people, the idea of borrowing a lot of money is terrifying to the point of paralysis.  I understand this perspective and I believe it is perfectly acceptable to ease into the process of using other people’s money to accomplish your goals.

The first investment property I purchased, I put 10% down (not uncommon in 2004) and I used all of my own money to finance the remodel or my duplex.  I had recently sold my primary residence, so I had the funds available.  Because I used up all my money on the first property, I had to get creative when the second opportunity to purchase a single family house came along.  I had a really clear plan to minimize the down payment, utilize an investor’s funds for the remodel, flip the house and pay the investor back. As you will see throughout this presentation, the common theme is that things rarely go according to plan. You can read more about how that deal actually unfolded at “Getting Started is Rarely Pretty.” But from a financing standpoint, I was able to refinance the house once the project was completed and cash out my investor.  I still own the house, ten years later, as a cash flowing rental.

A key point here is that if you structure a deal properly, you will have a whole lot more options when it comes to financing and re-financing.  The saying goes “you make money when you buy a property, not when you sell it.”  What this really means is that it is critical for you to understand the nuts and bolts about putting together a deal both from your perspective as an owner and from the point of view of lenders.  That’s a big part of what I am going to try to lay out for you.

I am a product of Robert Kiyosaki (among many other things).  I played is board game “Cash Flow” in August of 2004 and decided to try to put it into practice in my life.  By November of 2007, I owned 79 rental units.

One of the most powerful and simple concepts that Kiyosaki talks about is cash flow. Basically all it means is that when all is said and done, a property needs to have more money coming in then it has going out.  There are all kinds of sophisticated was to analyze property (and you should get familiar with them), but really what would be the point of buying a property that is not paying for itself?  Sure some people would tell you there are tax benefits to having a property lose money, but there are so many expenses you can write off in real estate, why not have it be profitable while you are also getting some tax benefits.  Also, the discipline required to find and acquire a rental property that actually cash flows will never fail to set you in good stead.

The reason why the concept of cash flow was so powerful to me right from the start was that I knew that I did not want to have to get a job.  I wanted my real estate investments to support me in the short-term and allow me to build wealth and plan for retirement in the long-term. I simply could not afford to buy properties that did not cash flow.  Again, cash flow means that after the rents have come in every month and all the bills have been paid, there is some money left over (to pay yourself).

When I started, I used to run my numbers by hand. I would write out all the property expenses and subtract then from the income.  I wanted to really understand what was going on.  In time, I built and extremely simple spreadsheet that I still use to this day.  Some investors might say my calculations lack sophistication because I don’t compare pre-tax and after-tax income. Or that I am not a real investor because I don’t use cap rates to analyze property.  Perhaps they are right.  What I have found, however, is that often times people use sophisticated calculations to mask the fact that the property is not actually cash flowing right now (which is the true indicator of profitability in my book).  Realtors are particularly guilty of this sin.

You need to develop a consistent standard to help you determine if you should buy a particular property, because there will always be a ton of people wanting to sell you property. It is actually the most common thing I say to people when they ask me my opinion about buying rental property: Does it cash flow?  Once I break out the spreadsheet, the answer is usually no.

This may be a little off topic here, but let me dispel the myth that there are no properties worth buying that are listed in the Multiple Listings (MLS).  My first two properties were listed in the multiple listing.  The best multi-family property I have bought to date was listed in the MLS.  There are opportunities everywhere and the more you refine your analysis skills, the better you will be able to see them and ignore the hype.

I used to carry around a pile of the listings for all the properties I looked at to remind me how many deals I had to research before finding just one I wanted to buy.  The ratio that I have heard is you look at 100 properties to find 10 to make offers on and you end up buying one.  It really does work that way.  What happens, however, in this process is that you get so much practice running numbers and analyzing properties is that when you find a good deal, you are ready to act.  It also helps you build your analysis muscle so that after a year or so of doing it, you get to the point where with just the gross rent and the address, you know if it is worth your time to drive by the property.

Yes, I did just say DRIVE BY the property.  Your smart phone and your Google Earth and your Truilla’s can only take you so far.  For better or worse, people choose to live in a place, a geographic location, a fixed point in space.  And if you are going to be the one trying to rent out a space for people to live in, you want to make sure you pick one that is desirable to people.  There are all kinds of amazing things that happen when you get out of your car and walk around a property (or several hundred).  You start to learn about foundations and roofing materials that are used in particular price brackets and neighborhoods. You begin to understand what features you can expect to see at certain price points.   You learn which areas have sewers and which places to avoid because they are on septic. And finally, you might encounter one of the greatest sources of information: the neighbors.

Often times, neighbors know more about a property then real estate agents and even the owner.  They, after all, are the ones who live next door to the property.  Neighbors often know who lived there, when and if they moved out, whether there was police activity, if there are boundary disputes, how cooperative the owner is, and the list goes on and on.  You cannot meet those neighbors through your computer screen.

OK, so I have gotten a little far afield from where I started talking about leverage and borrowing money.  Basically, when I did my first transaction, I wanted to use my own money to prove to myself that I could do it.  I needed to build my confidence in myself before I felt comfortable asking other people to use their money.  Interestingly, though, once I started using more leverage (less of my own money) I actually started to tighten up my numbers and get clearer about making a specific plan for the property.  I was willing to be more fluid with my own money than with someone else’s. So leverage actually began to hold me to a higher standard.

Eventually, it will come down to a point of your willingness to take a risk.  But it is very different to take an informed risk versus a reckless risk.  An informed risk is one in which you have done your research, built your skills and experience, made valuable professional contacts and then make the choice to borrow an amount of money that still might make your heart skip a beat.  A reckless risk is one in which you rely on someone else to tell you that it is “the deal of a lifetime,” you refuse to pay for solid professional advice and you just believe that all the pieces will magically fall into place.  In that scenario, you should be hyperventilating if you are signing loan documents.

Once you get the process down-more money coming in than going out-it becomes easy to start to grow your numbers. Think of the income and expenses like beans, rather than dollars.  No matter how many zeros there are after a number, there needs to be more beans coming in than there are going out.  Nothing magical changes when you buy a million dollar property (well, actually you realize how much more you are building in equity just by doing the same thing you were doing before, more on that later).  In fact, it is even more important to have strong cash flow because chances are good you don’t have $10,000 lying around to make the monthly mortgage payment if the property cannot support itself.

At this point you might be wondering why I am spending all this time talking about property research in a section that is supposed to be about financing.  It is because what property you choose to try to acquire is going to have a profound impact on your ability to get financing.

Once you are convinced that a property is worth buying, it becomes a lot easier to convince someone else that they want to put their money on the line to help you close the deal.  There are a lot of creative financing strategies out there, but we are going to start with the basics: How to convince a bank or credit union to give you a mortgage for your first rental property.

Working with Lending Institutions

It has taken me a number of years to start to understand how a bank or credit union looks at the world.  And that worldview changed significantly post recession.  Well, actually, I would say it just intensified rather than altered dramatically.  When dealing with a bank or credit union, you should think of them like a super conservative, super paranoid wealthy uncle who oddly wants to give all his money away before he dies.  If you don’t have one of them, use your imagination.

Let’s break this down, starting with conservative.  Lending institutions have very strict standards that they use to determine how and how much money they will lend you.  One of the first terms you need to know is loan to value ratio (LTV). Basically, what this means is that the bank is only willing to loan you a certain percentage of the value of the property.  The “value” of the property will be determined by an appraisal. Depending on the type of property, LTV’s can vary from 70 to 80%, with the limits tending to be higher on single family house.  For example, if you are looking at a house with a sales price of $100,000, the bank will be likely willing to lend you $80,000.  On a property with four or more units, the limits are more likely to be 70-75% ($250,000 sales price, mortgage at 70% LTV would be $175,000).

A note on appraisals: Appraisers are independent reviewers who are hired by the bank to determine the value of the property.  Appraisers seem to be the group of people who are experiencing the most residual effects from the recession.   Usually, if a property is fairly priced and sold under normal conditions (no one is being held at gun point), the appraisal comes in at or around the sales price.  In some situations, that may not be the case. Post-recession, some appraisers seem to be valuing properties in an ultra conservative manner.  Most likely this is due to the fact that over inflated values help to contribute to the housing collapse.  Values may also come in lower in a refinance situation, particularly if you are taking out equity from the property.

Back to the LTV issue, the bank is only willing to loan you a certain percentage of the value of the property because that helps to reduce their risk.  The concept is that if you have $20,000 of your own cash in the deal, you are less likely to stop paying the mortgage because you would lose your cash.  LTV’s are higher on a primary residence, because most people don’t intentionally want to make themselves homeless by having the bank foreclose on their house.  So for the purposes of planning your real estate investment strategy, you should assume that you are going to need to have some of your own money available.

In future posts, I will explore some creative ways to come up with the down payment that the bank is going to want to see before they will lend you money.

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Ode to QuickBooks

What if I told you there was a product out there that could streamline your business, provide valuable real-time data about your properties and virtually eliminate any hassle associated with filing your tax returns? Furthermore, if you use it properly, it can make you love tasks that you used to dread. And it will only cost you a few hundred dollars.  The product is QuickBooks.

I don’t care what free money management software came with your new computer. If you own rental properties, even just one, buy QuickBooks Pro. Now.  If you can point and click and have even the most basic typing skills, you can learn to use it.  One of the most beautiful things about Quickbooks is that you can ease into it.  When I taught myself to use it, I treated it like a computerized checkbook register.  Little did I know that in one step of data entry, I was creating all of the information that my accountant needed to do my tax returns, all of the reports my bankers would want to see, and valuable reports that would allow me to keep track of my tenant’s rent payments. My awareness of all of these built-in features came much later.

I was really clear when I started buying property that I wanted to build a four lane highway and grow into it (which I did when I went from 2 units to 79 in three years).  Quickbooks was the asphalt on that highway.  I am so grateful for this product (and it has been a long day) that I decided to write a little poem . . .

Ode to QuickBooks

In the past

My receipts would tatter

And day after day

I had no idea what was the matter

Try as I might

I lost sleep at night

Because I had no idea of my numbers.

On a fateful day

Not so long away

I taught myself to enter

Everything that brought my business to center.

Now I peacefully slumber

Enthralled by the numbers

Knowing that my data

Has nothing the matta’

And that when I awake

The cheerful noise you do make

Will let me know

That as I grow

I can do my books quick

And still have my pick

Of how to report

On my free time spent at the resort.

One of these days, I am going to post some links to help you learn to use QuickBooks.  Be sure to follow my blog, so you don’t miss that information (as well as any future dreadful poems).

How Many Landlords Does it Take to Change a Light Bulb?

Every once in a while, maintenance issue becomes simpler to solve then what you might have originally thought.  Enjoy those moments, because the scales seem to tip in the other direction more often.

Here’s a trick that might, just once in a while, save you from having to install a new light fixture at your rental property.

When you remove the bulb, inside the light socket is a little metal tab that makes contact with the base of the bulb.  Over time, this tab can get compressed or even just dirty.  With the power off (of course), using a non-metallic item (duh), you can gently pry up the tab a little bit so that it makes contact with the base of the bulb again.  I usually use an old fashion number two wooden pencil or the tip of a small plastic voltage meter.  Screw the bulb back in and if you are lucky, your problem is solved.

This tip is good to try on those light fixtures where tenants have tried replacing the bulb a few times, but none of them seems to work for long.  I learned this when one bulb wouldn’t light in a series of fixtures in a carport.  And yes, my electrician told me (fortunately he was there for another project).

Here’s the punch line: Just one, as long as the bulb is willing to pay rent once it is lit.

Checking Out Your Options Regarding Property Management Companies (part 2 of 2)

If you want to explore the option of hiring a company, here are some questions to ask perspective property managers:

  1. What type of property do you specialize in?
  2. What do you see as the role of the owner in the property management process?
  3. Will you require me to have an onsite manager?
  4. How do you work with on site managers?
  5. What does your fee include?  Lease ups?  Legal fees?
  6. Addressing problem situations:
    1. How long do you let a tenant fall behind on their rent before taking action?
    2. What is your process for dealing with noise complaints?
    3. What is the biggest challenge you have dealt with as a property manager and how did you handle it?
  7. Do you offer routine maintenance services?  Landscaping?
  8. What are the costs of these additional services?
  9. Does your company have a set policy on how you interact with tenants?
  10. Who is your accountant?  Attorney?
  11. Do you have a list of current clients who would be willing to talk to me about your services?

And don’t forget the rule of three (see “Working with Contractors” posted under Rental Property Maintenance).  Be sure to block out enough time to talk with at least three property management companies.  And don’t make your decision based solely on price, because it will probably end up costing you more in the long run.

If you are still on the fence about diving in and becoming a landlord, here are some unexpected benefits of managing your own property:

  1. Low vacancy rates—the more units you rent, the more you get paid. Self interest is a great motivator.
  2. The celebrity factor—I can’t set foot on my properties without everyone wanting to talk with me (and it is not always bad stuff)  Tenants, neighbors, contractors, everyone has something to say
  3. I have met people I never would have met in my ordinary life.  It is interesting.  It is better that TV.  It is like traveling without leaving home.
  4. You are a part of the community.  In fact, you are a leader in your community.
  5. You can make a serious positive impact on people’s lives beyond what you ever thought possible. Hopefully soon I will have an audio file posted that gives you a powerful example of this from one of my apartment buildings.
  6. You will learn more about yourself and realize your potential more than you ever thought possible—all while making money (hopefully)!!
  7. You get to create your own corner of the world.  For me, good manners are important.  I treat my tenants well and don’t tolerate bad behavior and, in turn, I am creating little pockets of better manners in the world.

Why Property Management May Not Be a Simple Solution (part 1 of 2)

OK, you are reading the books, you went to the seminars, you have saved some money up, and now you are ready to buy.  You have chosen your strategy and if you are successful, you are going to end up owning some real estate.  Hopefully sooner rather than later.

What I have noticed is that all of the guru’s tend to gloss over the part about what happens once you actually own the real estate.  The mantra seems to be “Oh, well, you can just hire a property management company to take care of it for you.”  Let’s explore why that not be such a simple, or even desirable approach.

  1.  Property management companies cost money, often 10% of your gross rents.  When you are just starting out, you may not have those kinds of margins.
  2. Many property management companies will not take on smaller properties, or they will require that you hire an additional on site manager (who you will also have to compensate)
  3. Property management companies often charge extras for things such as evictions, unit turn overs, and yard maintenance
  4. Property management companies do not share your self-interest of filling vacant units—they get paid regardless of whether or not the units are filled—you do not get paid unless there is some actual cash flow
  5. If you have never managed a rental property and maybe it has been a long time since you lived in one, how will you know if your property manager is doing a good job?  Could they be improving their performance?  How do you even have a baseline to judge from?
  6. Have you ever dealt with a property management company?  Did they leave with a warm and fuzzy feeling?  Were they a source of joy in the world?

So, whether your reasons are financial, developmental, or personal, you might need to think long and hard about the realities of putting your property under management.

Check back tomorrow for some specific questions to ask potential property management companies.

Still Learning After All These Years

A couple of years ago, I tried to start a website called “The Landlord School.”  I was doing all the right things, but I simply could not get it off the ground.  I had a complete crisis of confidence and refused to believe that anyone would ever want to listen to what I have to say.  So, after a few excruciating months, I closed up shop.

Recently, when I decided to try it again, I realized that the website name had been all wrong.  First of all, most people hate school.  And second, I certainly don’t want to be the teacher in charge.  Even though I am a landlord, I hate to tell people what to do.  And I definitely don’t see myself as the expert.  Sure a lot has changed over the last few years and I have overcome some insurmountable problems (I will tell you more about that when we know each other better).  But my business is still a work in progress.

So, a new name came to me “Learn to be a Landlord.”  Being a landlord is a process and I am an active participant in that process.  In fact, the thing I love the most about my business is how much I have had to learn in order to make it work.

I hope you can learn something from my blog posts.  And feel free to share your comments so I can learn from you.  Also, if you have a specific question for me, just click on the “Ask Jessica” tab at the top and ask away.

It Makes Me Nervous When You Say That

Today, I showed a one bedroom apartment to some potential tenants.  On the phone I had gotten the idea that there were some bumps in their past, but I always give people the benefit of the doubt and meet with them in person (unless they are a registered sex offender or some have some other major issue that does not meet my background screening criteria).  They called the day before to confirm the appointment, which was good, but then called in the morning to reschedule for two hours later.  It wasn’t a big deal to make the change, so I just went with it.

I asked them to bring their dog, a pit bull, so I could meet it.  The dog seemed friendly enough, but was constantly straining on the leash and seemed barely under the man’s control. Although they assured me that their little nieces can stick their hands in his mouth. Moving on, the dog goes back in the car and we go up to look at the apartment.

I always let people look around first to make sure the unit meets their needs and then I start to ask questions and go over the process.  The female in the couple starts to tell me that she “got in trouble” in the past.  A long time ago, when she was 18 and she is 23 now. (I think of a long time as 20 years, but that’s just me.)  She was in some kind of high speed car chase with a police officer, so my follow-up question was “Any drug charges?” Well, yes, and yes it was meth.  But lots of people will tell me that she is doing really well now, trying to turn her life around.

Rental History: They had lived in their current place for about a year and it was too expensive.  Also, her boyfriend has to do UA’s (urinalysis for drug testing) right down the street, so it would be really convenient for them to live here. His drug of choice-meth.

We moved on to source of income and she says she has worked for a few months at a bar owned by her friends.  And he keeps telling me he is on academic probation at the community college (but he says it like it is a good thing).  We talk about their credit and from their vagueness, I have a sense that there were probably a lot more issues there then they realize.

So all of this should make me nervous, and it does, but the thing that scares me the most is that he keeps saying “We will be really good tenants.”  Like about five or six times.  As his girlfriend is saying how he just got out of treatment, he is saying “We will be really great tenants for you.”  When I ask him about his criminal history, he says “We’ll be good tenants.”  He says it so many times that I finally say to him “It makes me nervous when you say that.”

I have rented to people with felonies and with other significant barriers and the ones who seem to do best are the ones who don’t beg for a chance.  The say what they did and what is different now and leave it at that.  I felt like this guy was trying to do some not-so-subliminal mind control hoping that the only thing that would stick in my brain would be “But they will be great tenants!” Needless to say, it didn’t work.

One of my Favorite Tools

As a landlord, I actually try to limit the number of tools that I own.  My belief is that the more tools you have, the more work you end up doing.  To this end, I also drive a Toyota Matrix station wagon, not a pickup truck.

Anyway, I do have a few favorite tools that don’t fit in the tool bag.  Today it was my drain snake.  Ten years ago, I don’t think I had any idea what a drain snake was and now I know I own at least two and maybe a third hiding in maintenance room somewhere.  It is a simple, hand-held device that allows you to run a long, thick metal spring into a drain and spin it around to clear a blockage.

In my experience, a drain snake is most effective on bathroom sinks and bathtubs.  You do have to disconnect the P-Trap (or J bend), but usually you can save yourself about $75-100, if you are willing to get a little dirty.  Make sure if you are going to use a snake, that no one has poured Draino down the sink recently.  Then messy becomes toxic.

As you incrementally push the snake further into the drain line while rotating it, you usually can feel when you hit the clog.  Also, when you pull the snake back out, you usually will find a clump of something wrapped around the tip (most of the time, hair, sometimes a dead bird).  For really clogged drains, I usually snake it a few times.

Here’s what I have learned in my seven years of snaking:

  • Bring gloves, channel locks, a roll of paper towels, a garbage bag, and  a bucket
  • The channel locks are to take apart the P-trap and the bucket goes underneath to catch the water (directly underneath while you are taking the drain line apart)
  • As you are pulling the snake back out, hold a clump of paper towels in your hand and run the snake through it to clean off the gunk. If you are really diligent, you will also spray it with WD-40 to inhibit rust.
  • Kitchen sinks are often better left to the professionals.  Handheld snakes just seem to be a little too small to solve the problem.

And of course, if you want to accessorize your drain snake, you simply must add a toilet auger and a Zip It.  The toilet auger is a little less fun to use since you are dealing with someone else’s waste, usually solid, but again, it can save you $100 if you don’t have to call the drain service (try $300 on Christmas Eve.  Bad call on my part!) It follows the same principles as the snake, although I seem to manage to break every auger I buy.  The Zip It is a cheap plastic strip that slides into the drain and grabs any hair that is close to the opening.  It is perfect for anyone with long hair and drains without good screens. I also use it when turning units over as preventative maintenance.

Finally, always be sure to show your tenants what you pulled out of their sink and tub drains (not so much on the toilet).  It can help prevent repeat performances in the future.

Happy drain snaking!

Accountability Theory

Over the years, I have seen that people actually appreciate being held accountable.  It shows you respect them enough to give them a chance.  Holding someone accountable is very different from establishing rules.  I believe that setting expectations is a sign of respect, whereas making rules starts from the belief that people are going to fail.

Of course, there will be plenty of rules at your properties, both your own and those required by the landlord/tenant laws in your state. What I am talking about are situations involving a specific tenant, usually around rent payments or disruptive behavior. When an issue arises, the first step is to communicate directly with the tenant. It is important that you are in a calm and controlled place emotionally before you start this interaction. So give yourself time to blow off steam and release any frustrations you may have about the situation.

There is a saying, I think written by T. Harv Eker in Secrets of a Millionaire Mind and it is this: “You can be right or you can be rich, but not both.”  I remind myself of this when I am in a heated situation with a tenant.  I always try to stay focused on my desired result (i.e. rent payment, prompt move out, the end of disruptive behavior) and adjust my behavior in such a way to maximize the chances of achieving that outcome.

Once you are having a conversation with the tenant, it is important to clearly establish what you want them to do and when you want them to do it.  Most tenant issues follow this pattern.  You want them to pay their rent by a certain date or move out by a certain time or turn down their music after a certain hour. If there is any confusion about your expectations, put them in writing and give a copy to the tenant.  If it is a chronic issue, that written statement should be an official notice (i.e. a 3 Day Pay or Vacate or 10 Day Comply or Vacate).  For a tenant who is behind on their rent, you might just write up a simple letter that they sign, with the understanding that if they do not comply, they will be served with an official notice.

Once your expectation is clear with the tenant, it is your job to follow up if they are not being accountable to their agreement.  It is so easy to let this critical piece slip through the cracks, especially if you are frustrated with the tenant.  Don’t let that happen! Write a note in your calendar to remind yourself to follow up. I am often writing myself notes like “Joe, pay $300” or “Check with neighbors at lofts about noise” on specific days in my planner.  It is important for the tenant to know that you take your agreement seriously.  If you don’t follow up with them, they will know that they can continue to get away with whatever they were doing.  A simple phone call or text message is often all it takes to keep them on track.

It Doesn’t Matter if They Like You

Ideally your tenants will like and respect you, but when in doubt, go for respect.

One of the things I tell potential tenants is that I am really clear about my role as a landlord.  I am not there to be their mother or their friend.  My job is to be their landlord, which means I make sure everything is working in their home and I help resolve any issues that come up.  Any tenant who has had a landlord with poor boundaries really appreciates hearing this from me. One of my biggest landlord peeves is when people tell me that they had a landlord that would just show up in their living room.  Not only is that illegal, it is also a complete invasion of people’s privacy.

As a landlord, you are sort of like a police officer.  No one really wants to run into you, but when there is a problem, you are the first person they think to call.  It can take a little while to get used to this role, but it is best for everyone if you maintain it once you have it.  I am not saying don’t be friendly with your tenants and even get to know them personally, but draw the line at becoming friends with them.  I have a lot of cool tenants, some of whom have even invited me over for a glass of wine or to hang out at their bonfire.  I know I can’t because when they pay their rent late, it will be that much harder to give them a 3 Day Pay or Vacate Notice.

By being available for my tenants by phone and professional in my behavior, I can help establish a calm sense of community at my properties.   I do not participate in gossip or share my own personal or political beliefs.  I try to be neutral and focus on the interests of the tenant or potential tenant.  Unless someone says something that is outright offensive or blatantly discriminating, I just let people speak their mind.

There will be occasions when people don’t like what you have to tell them (i.e. “Yes, you do need to pay your rent.” “No, you can give.me a week’s notice and move out and expect your security deposit back.”), But if you strive to communicate in a calm and professional manner, chances are good that they will hear you and in the end you will get the results you want.  Sometimes the best thing to do is to say nothing at all and let the agitated tenant talk themselves down.

If you have done your job when people move in, the tenant should have a clear understanding of your policies and landlord tenant law. And if you have good systems and forms, you should have written instructions for many common situations. Even though they know the rules, people often try to push the boundary to see what they can get away with.  Hold firm and stay on message and they will bring themselves around.  You are running a business, not a social club.  Your bank doesn’t care if your tenants love you; they want you to pay your mortgage on time.

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