Real Estate Investing: Buy and Hold Strategy (Residential Properties)

by FI Fighter on April 24, 2014

in Real Estate Thoughts

buy_hold

There are many ways to build wealth through real estate, and one of the most popular methods investors use is to Buy and Hold residential properties. If financial independence is the name of the game, then the Buy and Hold strategy might be the perfect fit for you.

Introduction

In a nutshell, being financially free implies that you never have to work for money again. This means that you own investments that supply enough cash flow each month to cover all your monthly expenses. With the Buy and Hold approach, investors focus their efforts towards acquiring properties that are cash flow positive each month, even after accounting for all rental expenses and reserves. The Hold part of the strategy is exactly as it sounds — you hold the property for a LONG period of time. If you buy right, you should never have to sell! Why part with a cash cow that puts money in your pocket each and every month? As Warren Buffet likes to say, “Our favorite holding period is forever.

Just Like Dividend Growth Investing

The Buy and Hold strategy in real estate investing is akin to Dividend Growth Investing (DGI) used by stock investors. With DGI, the primary focus is on the rising dividend payouts, not on the underlying value of the stock. In fact, many dividend growth investors are so focused on the dividends alone that they train themselves to completely tune out the day-to-day fluctuations affecting the stock price. Performance of a dividend stock is judged on the consistency of the dividend payout (Dividend Aristocrats are highly revered for their time-tested history of being able to make timely payments), and the ability of the company to keep increasing the dividends on a yearly basis.

The following graph shows 1-year history for Procter and Gamble (PG):

PG_1_Year

https://www.google.com/finance

As you can see from the chart above, the stock price experiences a lot of volatility in the short-term. However, the focus is not on the share price, but on the consistent distribution of the dividend payouts.

Here is a graph showing the 5-year history of PG:

PG_5_Years

https://www.google.com/finance

Over a 5 year period, the stock price fluctuations dampen out, and the general direction (up) becomes more obvious. Most important of all, the stock continued to pay an increasing dividend each quarter without fail. In 2009, the quarterly dividend payouts were $0.44/share, and in the most recent quarter of 2014, the payout was $0.60/share. This represents a dividend growth of 36% in 5 years.

Real Estate Investing

In a perfect world, just like with stocks, a real estate investor will be able to locate a property that consistently increases cash flow on a yearly basis without fail. A good investment will also rise and appreciate over time, even if just gradually like the PG example above. For a Buy and Hold strategy, appreciation is never the main focus, but just like with stocks, the right investment should only become more valuable over time.

To get started on the right foot, the prospective Buy and Hold investor needs to run cash flow analysis numbers and ensure that the investment property they are purchasing meets their cash flow needs.

Class A+: Best of the Best Scenario

The reality is, most properties out on the market will make for bad Buy and Hold investments. As an investor, you must remember to keep your emotions in check; you are buying a property to make you money, not to live in!

Dream house in Cupertino, CA:

cupertino

http://www.redfin.com

Cash flow analysis: 8% PM Fee; 5% Vacancy; 5% Maintenance

Cupertino_Cash_Flow

This example is clearly over-the-top, but you might be surprised with how often investors make the mistake of overpaying for a rental property. The Buy and Hold approach (in its purest sense) does NOT rely on appreciation, which is what you would be banking on if you were to purchase this property as a rental. Why else would you drop $422,000 in downpayment? To lose money each month???

Class A+ properties are the cream of the crop. These are the dream houses and McMansions out in the suburbs that homeowners fantasize about living in. Either that, or they are the swanky apartments and condos located in the bustling city core.

Keep in mind, the residential real estate market will never make financial sense because the price of the property isn’t determined using the income approach (residential properties are appraised using sales comparison approach). Rather, the price is set by the emotional homebuyer who must own in the best neighborhoods.

This is what you would be paying a premium for:

cupertino_zillow

http://www.zillow.com

If you are an investor who demands the absolute best of the best, and price is no object, Class A+ properties are the most suitable type of investment for you.

Here are the pros and cons for Class A+ properties:

Pros:

  • Located in the safest and most desirable neighborhoods (e.g. best school districts).
  • Easy to sell (lots of competition from homeowners).
  • Tenants will be extremely well qualified.
  • Rents should rise rapidly and exceed rate of inflation.

Cons:

  • Cash flow negative (probably for many, many years).
  • HUGE downpayment or capital required.
  • May be more difficult to rent out (only affordable by the most affluent).

Refined Criteria

As an investor, you must refine your criteria and go with what works best from a financial point of view. Again, never fall in love with an investment property! So, if you want to maximize your Return On Investment (ROI), unfortunately, this probably means that you shouldn’t be investing in premiere locations where the schools are all rated 10/10. Or a block away from the financial district…

Class A: Very High Quality Scenario

Since Class A+ properties will be out of reach for most investors, a good compromise would be to “settle” for the next best thing — Class A properties. Class A rentals will offer much more bang for the buck since you won’t be competing with the wealthiest homebuyers. Instead of buying into the absolute best school districts, you’ll be settling for 8/10, or 9/10 ratings, which are still more than respectable. Class A neighborhoods are very desirable and sought after, so you should have no trouble locating stellar tenants with 700+ credit scores.

Rental Property #2 is a good example of a Class A property. It is located in a very safe neighborhood that offers easy access to freeways, jobs, and public transportation.

As such, Rental Property #2 fails to meet the 1% Rule… even though I purchased it at the bottom of the market cycle! In today’s hot market, the returns on Rental Property #2 are even more abysmal.

Cash flow analysis: 0% PM Fee; 5% Vacancy; 5% Maintenance

Rental_Property2_Cash_Flow

Yikes! The Cash-On-Cash Return is only a paltry 2.68%… and that assumes 0% PM fee (self-manage). You can imagine how disastrous the cash flow numbers would look plugging in today’s prices (2013 Purchase Price = $290,000; Today’s Price = $396,917)…

So, was Rental Property #2 a good Buy and Hold? Absolutely! Again, when you are purchasing high quality properties, be prepared to pay fair market value for them. With Rental Property #2, I have peace of mind. It’s extremely easy to rent out (I could run a Craigslist ad over the weekend and have over 10+ offers by Monday morning), and I don’t have to worry about locating a quality tenant; they are a dime a dozen.

As such, if your holding period is over many years, it may make a lot of sense to accept less cash flow today, and hope for better returns in the future. Yes, it is always speculation when you play the “what if” game, however, you can mitigate risks by buying properties that are cash flow positive from Day 1. Since Rental Property #2 was cash flow positive from the start, I was more than comfortable taking that gamble. I had 100% conviction that I was buying into the right neighborhood; it is located in an area that should continue to see sharp rises in rents over the years.

Rental Property #2 has also appreciated substantially since I purchased it, but that is a topic of discussion that will be addressed in a separate article…

Rental Property #2 valuation today (April 23, 2014):

Rental_Property2_Zillow

http://www.zillow.com

Based off of today’s market numbers, Rental Property #2 should command $2,459/month in rent. The current tenant is paying $2,150/month. This is a market rise of $300/month in less than one full year since renting it out (May 2013). If you buy in high quality growth areas, it isn’t far fetched to see rents climbing rapidly over the years. In most cases, the rents captured by Class A properties will easily outpace the rate of inflation. Over time, this will help an investor increase cash flow and yield. In real estate investing, nothing is ever assured, but steady rent appreciation through the years is made possible by buying into great neighborhoods; this is a strong factor as to why some investors will be willing to accept a lower return today.

Cash flow analysis with revised rent: 0% PM Fee; 5% Vacancy; 5% Maintenance

Rental_Property2_Cash_Flow2

In a little less than a year, the Cash On Cash Return has jumped by ~6% to a more respectable 8.44% (plugging in revised rent of $2,459/month). With a 30 year fixed mortgage, the returns should only increase further in the future.

If you are an investor who wants to build up a portfolio made up of extremely high quality properties that are painless to rent out, and you are willing to accept minimal returns the first few years (i.e. you are patient and your investment time horizon is relatively long), Class A properties are the way to go.

But keep in mind that the barrier to entry for Class A properties can be quite high. Rental Property #2 required $58,000 in downpayment funds.

Here are the pros and cons for Class A properties:

Pros:

  • Located in excellent, high demand neighborhoods.
  • Easy to sell (lots of competition from homeowners).
  • Tenants will be well qualified.
  • Rents should rise rapidly and exceed rate of inflation.

Cons:

  • Cash flow and Cash On Cash Return will be abysmal, or even negative when first starting out.
  • Large downpayment or capital required.

Class B: The Middle Ground Scenario

Rents don’t typically scale with purchase price which helps explain why the ROI for Class A+ and Class A properties are so low. For instance, it is very easy to locate $100,000 properties that rent for $1,000/month. It is more difficult, but still possible to locate $200,000 houses that rent for $2,0000/month. As purchase prices increase further, it gets increasingly more difficult. It is next to impossible to find $300,000 properties that rent for $3,000/month, and unheard of to find $400,000 ones that rent for $4,000/month. The Class A+ example was a $1,688,000 home that can only command $4,500/month in the marketplace…

As investors, you take what the market gives you and you look for that “sweet spot”. When it comes to locating strong cash flow rental properties, most investors will settle somewhere in the $60,000 to $200,000 space to maximize ROI. Of course, this range will vary greatly from location to location. In the Midwest, it may be possible to locate a $200,000 home in a Class A neighborhood. In an expensive market like the Bay Area, $200,000 can’t even buy you a property in a bad Class C location…

In most cases, Class B falls in the realm where you are most likely able to achieve a nice balance between quality and ROI.

Class B in Round Rock, TX:

Round_Rock_Zillow

Cash flow analysis: 8% PM Fee; 5% Vacancy; 5% Maintenance

Round_Rock_Cash_Flow

The above property has a lot going for it. It is affordable, almost hits the 1% Rule, is located in a great neighborhood, and will cash flow from Day 1, even after accounting for a PM (8%) and vacancy + maintenance reserves (5%). The Cash On Cash Return isn’t the highest at 4.13%, but it is better than what you will find in the Class A+ and Class A space.

If you are an investor who wants to invest in high quality and expects decent cash flow from the get go, Class B properties will fit the bill.

Here are the pros and cons for Class B properties:

Pros:

  • Located in very good, desirable neighborhoods.
  • Tenants will be qualified.
  • Rents should rise at a moderate pace and track (or exceed) inflation.
  • Reasonable downpayment or capital required.

Cons:

  • Cash flow and Cash On Cash Return will be marginal, starting out.

Class C: High Yield Scenario

As we venture into the Class C space, we start sacrificing quality in return for higher yields. Depending on each individual investor’s own risk tolerance, this may or may not be a suitable path to venture into. When investing in Class C properties, the importance of having a high quality PM in place becomes increasingly more important. You should expect to see more vacancies, and you should definitely allocate more funds for maintenance reserves.

In my own portfolio, Rental Property #3 and #5 are Class C properties (both are duplexes). Rental Property #4 is probably more along the lines of Class B-/C+, but at worst would fall into Class C.

Cash flow analysis: 8% PM Fee; 10% Vacancy; 10% Maintenance

Chicago_Returns_5

Even after accounting for PM fees (8%) and vacancy (10%) and maintenance (10%), Rental Property #5 still returns 13.76%. Because there is added risk in this type of investment, a high yield from Day 1 is absolutely a requirement to purchasing.

With a Class C property, you should not expect a passive investment. At best, the property will be semi-passive. Plan on allocating sufficient time each week to monitor and follow-up on all the happenings of your investment. If you hire a PM, make sure you stay in constant communication, perhaps once each week. The reality when investing in Class C properties is you are not going to be renting out to the most qualified tenants. Class C properties are extremely affordable for a reason! The affluent white collar professionals do not live in these properties or neighborhoods. You should expect the majority of tenants in these parts to be blue collar workers who may have had credit problems before in the past… With Class C, however, the quality should be good enough where you NEVER have to rent out to felons, or anyone who has an eviction on their record.

If you are an investor who is willing to take on more risks to obtain a higher yield, Class C properties provide what you are looking for.

Here are the pros and cons for Class C properties:

Pros:

  • Extremely high cash flow and Cash On Cash Return.
  • Extremely affordable; only small downpayment or capital required.

Cons:

  • Decent, or mediocre neighborhoods.
  • Will be more difficult to sell.
  • Prospective tenants will be average, or below average (Don’t expect 700+ credit scores).
  • Need to set aside more funds for vacancy and maintenance reserves.
  • Rents may be static, or rise more slowly relative to Class A, or Class B investments.

Class D: Warzone Scenario

Class D properties (and anything below) are not worth an investor’s time. No matter how cheap the investment is, or how high the returns look on paper, the risk is not worth it. Getting into a warzone neighborhood is just asking for trouble…

Mixing It Up

As a real estate investor who is looking to build up a portfolio consisting of Buy and Hold rentals to generate cash flow each month, it may be a good idea to diversify your holdings across the different Classes (A-C). As discussed above, there are pros and cons for investing in each type of investment property.

For my own portfolio, I currently hold the following:

Class A+: 0
Class A: 1 (Rental Property #2)
Class B:1 ( Rental Property #1)
Class C: 3 (Rental Property #3, #5, #4)
Class D: 0

The Class ranking is subjective and not every property will fit perfectly into any one group. In my own portfolio, Rental Property #4 does not quite fit into Class B, but is probably a cut above Class C. I would rank it somewhere in-between, at Class B-/C+. However, if I was forced to categorize it within the system used above (Class A-D), I would peg it as a Class C rental.

For an allocation of ten rentals, I might aim for the following blend:

Class A+: 0
Class A: 1
Class B: 5
Class C: 4
Class D: 0

If I were to follow these guidelines with my future purchases, I would need to acquire four more Class B’s and one more Class C. Every investor will have their own preference, so you must allocate in a manner that best fits your criteria and investment goals. A portfolio consisting of ten rentals was ONLY used as an example — you may elect to acquire more or less, depending on your own needs.

Summary

The Buy and Hold strategy is a very popular and effective strategy that can help a real estate investor build up semi-passive cash flow. Just like with Dividend Growth Investing, the main focus with Buy and Hold properties is on obtaining consistent cash flow that increases over time. By buying into the right Classes (and diversifying accordingly), an investor can position themselves to reap the benefits, while mitigating risk.

If your investment style is more risk adverse, seek out higher quality Class A or Class B properties that yield a lower ROI initially, and build your wealth gradually over time. If you want higher yield and can stomach the risks, you may want to incorporate some Class C products into your portfolio. There are no obvious right or wrong answers (except for avoiding Class D and below), and you will learn over time which type of investment is best suited for your personality and goals.

Best of luck in your investing endeavors and happy hunting!

{ 21 comments… read them below or add one }

1 Ikio April 24, 2014 at 2:28 am

Excellent post, but I’m worried about the fact that you take on debt (i.e mortgage) to fund your financial independence… I see this is as somewhat of a contradiction, how do you reconcile this?

Thanks
(an avid reader from Israel)

Reply

2 FI Fighter April 24, 2014 at 8:30 pm

Ikio,

Debt, or leverage can be a double edge sword… Yes, a person who is going to use it definitely has to be more careful and build a solid (large) cash buffer.

Leverage is without question a riskier way to get to early FI… but also perhaps the most powerful (easiest) way to get there quickly… Always be extra careful though. And by no means is leverage for everyone. Each investor must assess their own risk tolerance and comfort level with taking on more debt.

Take care!

Reply

3 No Nonsense Landlord April 24, 2014 at 4:44 am

Buy and hold has worked great for me, although I did one flip last year which I just posted about on my blog that was very profitable.

Understanding the neighborhood and apartment classifications is also key. If you do not understand it, and many Realtor’s do not, they unknowingly ‘trick’ you into a sub-par property with a 10% return. 10% is not enough for a class D property.

Before any buy and hold strategy, it is important to know what your other options are. If you can make 5% in a C/D (like the old days), a 5% cash flow is not enough for RE, as the risk for RE is greater.

Investing for cash flow now, is key. never invest for appreciation, or depreciation. Those are bonus’, just like bad tenants are…

Reply

4 FI Fighter April 24, 2014 at 8:33 pm

Eric,

I think it’s great that you combine both buy and hold with flipping to earn a quick buck. There’s no reason why you can’t do both… Although if your plan is to get to early FI I think the biggest focus should be on building up the cash flow (buy and hold).

I don’t think any return would be good enough to get me into a Class D property… I think C is as risky as I’m willing to go…

Good point on buy and hold… If the returns are too low, it might make more sense to just stick with stocks, or a more passive income source.

Take care!

Reply

5 The First Million is the Hardest April 24, 2014 at 11:58 am

To buy and hold is really the only reason I’d get into rental properties myself. The constant income is far more appealing than any profit from flipping a house. I like the comparison to DGI, it makes the concepts of assembling a real estate portfolio a little easier to understand for someone like me 🙂

Reply

6 FI Fighter April 24, 2014 at 8:34 pm

Jay,

Yeah, I’m with you and my focus is primarily on buy and hold. Building that income stream is what will get you to early FI.

I feel like DGI and Buy and Hold are very similar… Lots of people do both to diversify even further. I will myself once I max out my 10 loans…

All the best!

Reply

7 Anny April 24, 2014 at 6:58 pm

Do you have an exit strategy for your class C properties? Thanks for such amazing posts. I’ve learned so much.

Reply

8 FI Fighter April 24, 2014 at 8:36 pm

Anny,

Very good question! In terms of exit strategy, I would need to hold at minimum 4-5 years in order to get my cash back out…

After that, I will reassess where each property is at and determine if it makes sense to hold or sell. Selling shouldn’t be difficult in an up market… it’s when the market crashes where I’d be most concerned. The true test of the buy and hold will come in those dark times… If I can weather a few of those, I’d be confident in holding long term.

We’ll see… But the exit strategy for Class C is definitely more hazy than Class B or Class A. With those, it shouldn’t ever be too difficult to sell.

All the best!

Reply

9 Zee April 25, 2014 at 12:03 am

That was very informative, I rent out rooms in my house so I’m a landlord, but honestly I’d rather have a smaller house and live by myself. (this may be coming sooner rather than later for me, but we’ll see) I really don’t like having to be a landlord, I’m sure it’s a lot different if you don’t live with your tenants though.

Because of my experience I don’t think I would ever get into owning multiple properties, but I always wondered the criteria and judgment that took place when looking for potential properties. So once again, this was very informative and I may keep these things in mind the next time I move.

Reply

10 FI Fighter April 28, 2014 at 10:04 pm

Zee,

I hear you and I think along the same lines — smaller house is better.

Yeah, rentals aren’t for everyone… even if you outsource and hire a PM, it will never be as passive as stocks…

Glad you found the article useful.

All the best!

Reply

11 Jason @ Islands of Investing April 27, 2014 at 3:31 am

Hi FI Fighter, fantastic article! This was a fascinating read for someone who solely invests in shares.

One reason I’ve never been tempted to venture into property is that property prices here in Australia are ridiculously expensive – among the most expensive in the world when compared to average incomes. Cash flow positive properties are pretty hard to come by, and yields are extremely low, yet there seems to be no end to the enthusiasm for buying property here at the moment. Feels a little like ‘building castles in the sky’ – everyone’s counting on selling to someone else for an even higher price in future.

Another thing investors get caught up in here is ‘negative gearing’ – a tax rule where cash flow negative properties receive a tax deduction for the loss. Many people love this strategy, and is their primary reason for investing in property, but it relies on asset prices and rental yields increasing sufficiently over time – and means you’re losing money now! I think scrapping this policy would impact prices here significantly.

Also love your comment on dividend investors who are able to tune out the day to day price movements of shares. This is a hard thing to do, and is definitely one thing property has going for it – no constantly updating prices flashing on the property’s front door. I think this leads to many bad decisions for share investors who check prices frequently.

If I ever feel the need to diversify into property (outside our primary residence) I might look into the US market and come back to you for some tips! Great stuff!

Cheers,

Jason

Reply

12 FI Fighter April 28, 2014 at 10:06 pm

Jason,

Wow, that does sound like a pretty tough environment to be operating in for an investor… I’m not sure I’d be so gungho about buying properties either if the cash flow wasn’t there at all…

Taking a tax break to go negative just seems very counter-intuitive… Not really sure how folks see the benefits of that.

Yeah, as long as the property is cash flow positive, then as income investors, we are just happy to see consistent and rising payments… It doesn’t really matter what the price of the asset is…

Feel free to reach out anytime, if you want more info about U.S. properties.

All the best!

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13 Long Term Brian April 27, 2014 at 5:37 pm

Great post! Full of great information.

I’ve thought about real estate investing in the past, but never took the plunge.

If you were starting from scratch, would you aim for nothing but class ‘c’ properties?

Long Term Brian

Reply

14 FI Fighter April 28, 2014 at 10:10 pm

Brian,

Thanks! That’s a great question, and a tough one to answer…

I guess the short answer is, it depends on the current market environment… In general, my own philosophy is to only buy cash flow positive properties, regardless of where we are in the cycle.

Class C’s are good b/c they are affordable and provide a lower barrier to entry. Also, cash flow and yields are typically higher…

In an up market, it’s difficult to find Class B and Class A that cash flow reasonably… you might even start out negative. If that were the case, I think Class C looks more attractive.

In a down market, Class B’s and A’s start to be more cash flow positive… even if the yield is still pretty low. In this type of market environment, I would roll the dice and go with the B’s and A’s. You get the cash flow now and if you buy right, you increase your odds of getting lots of appreciation later. I would take the combo of high quality + decent cash flow + strong appreciation potential any day of the week, personally.

Hope that helps.

Take care!

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15 Stefanie @ The Broke and Beautiful Life April 28, 2014 at 5:43 am

I wonder if I’ll ever have enough cash to get into real estate investing. The thought of having enough for a downpayment to buy a home for MYSELF still feels far off.

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16 FI Fighter April 28, 2014 at 10:13 pm

Stefanie,

Yeah, it can be a slow process starting out, for sure… When I started, I never would have dreamed that I would own 5… let alone try and aim for 10 or more…

The good new is that investing gets easier over time. You get the compounding, and if you remain frugal, you can add your work income on top of that to buy at an even more accelerated rate. Getting started is always the most difficult part… It does take some time in the beginning.

All the best!

Reply

17 Brent @ All About Interest April 29, 2014 at 1:46 pm

Nice write-up on the different levels of properties out there. My most recent purchase was by your definition a Class B , ironically in the suburbs of Austin, as your example is. I’m now debating to keep adding to my DG portfolio as much as I intended or to save up for a 4th rental later in the year. I love the diversification that both investing strategies bring. I suppose that’s a good problem to have and I’ll be watching the market for sure. I’m pretty happy with how fast the last rental leased. I’ll have to post about that soon.

Cheers

Reply

18 FI Fighter May 5, 2014 at 10:38 pm

Brent,

Wow, what a coincidence! Austin is a great market; you get good appreciation and some cash flow. The ranking I used is subjective, and I would put the $150k properties in Class B.

I think you have a winning strategy all the way around! DGI and REI go very well together and you are absolutely killing it with your progress.

Cheers!

Reply

19 Jason April 29, 2014 at 4:54 pm

Great summary of the general options, FIF!

One thing I’ve been thinking about is the debt incurred on rentals and how best to deal with it and work it into a retirement plan. (Another poster alluded to this as well).

Mathematically, it’s easy to give the optimal answer; you should get to and maintain a level of debt so that your debt-to-income stays “appropriately safe” throughout the investment. (This level should vary according to your personal comfort level). But, this doesn’t give much of an exit strategy.

What I’m trying to do is to maintain a certain amount of debt while allocating some cashflow for debt relief and some cashflow for new purchases. As older properties get paid off on the back-end, new properties get added to the front-end. Once I’m close to my target passive income, new purchases will taper off and more cashflow will get put into the mortgages. Then, when most/all properties are F&C, I’ll be done.

At least in theory… ha!

Reply

20 FI Fighter May 5, 2014 at 10:42 pm

Jason,

I love the idea of debt relief and that’s something I would like to focus on myself once I’ve cleared 10 loans.

If I can get to 10, I should have everything I need to declare FI, even with mortgages. After that, I would focus on paying a property down, one at a time. At some point if I can get to 10 free and clear, I should have all that I need… More would just be gravy.

Definitely it is a good idea to keep the debt to income in a safe range! It’ll be so fun once you get to all properties F&C! 🙂

All the best!

Reply

21 Al Harris February 15, 2015 at 8:10 am

Wow! great information, thanks.

I am in Milwaukee WI and my current purchase limit per property is 30K all in. My last purchase is a duplex under 10K all in with 2 elderly renters paying $500 each.

I love the Milwaukee opportunities right now.

Reply

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