BiggerPockets

Investing in Real Estate: Taming the Fear

Wednesday, March 11

Most real estate investors are aware of the terrific positive cash flow opportunities with cash-on-cash returns in double digits on single family homes.  Yet many have chosen not to invest out of fear that the value of their investment property will fall.  How founded is that fear?  Consider what the numbers tell us.

Take the example a $60,000 1100 square foot, 3 bedroom 1 bath house in Jackson, Mississippi, already renovated with a tenant paying $700 per month.  With a 20% down payment, and allowing for mortgage payments (PITI), property management, maintenance and vacancy, the property will still return well over 10% per year (over 15% if the tenant stays in place and takes good care of the property.)  That is clearly a great return on investment.  But how much downside is there?  Will the $60,000 house materially drop in value?

Prices will not fall if there is adequate demand for housing.  Consider that if the foregoing tenant were to purchase that same house with 5% down with an FHA loan at a 5.5% interest rate, his total monthly payment (PITI) would be about $436, about 38% less than the $700 he pays in rent.  Plus, his savings would be even greater because his interest payments and property taxes are tax-deductible.  So it is compelling for the tenant to buy instead of rent.  When we hear of “pent-up demand” for purchasing homes, this is one of the main reasons why. 

So why doesn’t he buy?  He sure wants to.  It boils down to making the down payment and qualifying for the loan.  Generally, the greater challenge is the latter.  With the mortgage default rate so high, lenders have greatly tightened their standards, so it is harder for prospective homeowners to qualify for loans.  However, the Obama administration has unveiled a number of initiatives to address this problem and enable people to once again purchase homes, such as a 10% tax credit (up to $8,000) for first-time home buyers in 2009.  As these initiatives take root and more people can qualify for loans, housing sales will increase significantly, as there is huge pent-up demand.  This, in turn, will stabilize prices, and will likely cause prices to begin rising. 

Properties today have such strong positive cash flow that they effectively mitigate the downside risk in further slippage in home price.  Also, while prices have fallen throughout the United States, in some areas of the country prices have fallen only slightly, such as in Mississippi, as these areas never had a speculative housing bubble like the East and West coasts did.  So there is less downside risk in these markets, generally in the center part of the nation.  With the pent-up demand for housing soon to be unleashed and compelling cash flow returns, there has never been a better time to invest in real estate.

Cash Flow - or is it?

Wednesday, February 25

We all have seen extravagant claims of thousands of dollars in cash flow advertised by various Get Rich Quick real estate investment schemes. Positive cash flow is always an attractive advertisement but if you look closely, many of these claims are false.

To better understand cash flow of an investment property, it is important to identify the three primary ways that real estate investments provide a return; through appreciation, cash flow, and the reduction of principal (pay down of debt). Each investment will generally capitalize on one, or more of these elements. Building equity through appreciation and paying down the mortgage are generally well-understood by most investors. Cash flow is much more ambiguous.

On the surface calculating cash flow is fairly straightforward. Cash flow is simply the difference between the checks you receive every month, and the checks you write. Where most people run into trouble, is when they deal with sellers of real estate investments that have a much looser definition of cash flow, or make unrealistic assumptions relating to rental income or expenses. The most common elements of cash flow that are misstated are rental income, which are overstated, or expenses which are understated, or omitted entirely.

Using an example of a $100k home, let’s calculate the true before-tax cash flow (BCTF) assuming the home is rented at $1000/month with a 5% vacancy rate. Property management is 10% of the gross operating income (GOI) and the repair allowance is 5% of GOl. Property taxes and insurance are each determined to cost $1000/yr. The mortgage is at 7%, amortized over 30 years with a 10% down payment resulting in an annual payment of $7995.

In this example, the home has a Gross Scheduled Income of $12,000/yr less $600 in vacancy costs resulting in an annual GOI of $11,400. After subtracting the remaining property management, taxes, insurance, maintenance, and debt service costs totaling $11,795, this home winds up with a negative cash flow of $395 a year.

Yet sellers of investment properties will often claim that the cash flow is positive. This is because it is common for marketers of such properties omit many of the expense categories to make the cash flow sound larger than it actually is. It is incumbent upon you, the investor, to perform your own due diligence. Study the seller’s numbers. Most of the components of the cash flow calculations are precise numbers which can be identified or estimated very accurately such as rents, property taxes & insurance, management expenses and the mortgage payment. The vacancy rate, repair allowance and utilities (if paid by the landlord) must be reasonably estimated. After factoring in appreciation and pay down of the loan, an investor can make an informed, lower risk decision when purchasing investment property that will deliver exceptional returns.

Real Estate as an Alternative Investment

Wednesday, February 25

The goal of investors is to maximize their risk-adjusted return on their investments.  Traditionally, most investors do this by diversifying their investment portfolio across a range of investments that include stocks, bonds, and fixed return instruments such as CD’s and money market funds.   

Real estate is an asset class that should be an essential part of an investor’s investment mix.  Real estate investments offer outstanding returns at low risk over the long course of time, and its performance is not closely correlated with other asset classes.  Despite the turbulent times in the stock market over the last ten years, where the S&P 500 stock index produced a negative return through January 2009, residential real estate was up +4.6% per year over the same time period.  And by using the power of leverage, investment returns should be able to exceed 20% per year even with modest appreciation.

Real estate has been under-represented in investment portfolios because good property investment vehicles have not been easily available.  For many investors, their home has been their main real estate investment.  Others have branched out into Real Estate Investment Trusts (REITs), which have become increasingly popular over time.  REITs have offered good liquidity, and good overall returns, but tend to be volatile, with returns that may vary widely year-over-year.  Their other big drawback is since REIT dividend income is fully taxable at ordinary income tax rates; they are best suited for tax-advantaged accounts, such as 401(k) plans and IRAs.

Many large fortunes in real estate have been amassed by buying and holding properties to generate significant returns through cash flow and appreciation, and by taking advantage of their tax benefits, notably depreciation, long-term capital gains tax treatment, and the ability to defer tax liabilities through the use of 1031 tax-deferred exchanges.  Buying and holding properties offers some of the very highest returns, stability, and tax advantages available.  

Real estate can be owned in several forms, including commercial real estate and single family residences.  Commercial real estate, while offering compelling returns, generally requires significantly more investment capital than single family residential real estate and is more complex to acquire and manage.  Consequently single family homes represent an easier and lower risk path for first time investors.

While there are many successful investment models in real estate, they all share only one or both of the following fundamentals to build financial wealth: cash flow growth and equity build-up.  Most homeowners are familiar with equity build-up, which is driven by the appreciation of a home and/or paying down a mortgage balance over time.  Equity build-up increases one’s net worth in real estate assets.  

Cash flow relates to deriving rental income in excess of all of the cash obligations and costs incurred, including the servicing of mortgage debt.  To the extent that costs can be reduced and rents appreciate, cash flow will grow over time. 

Some of the best and most stable investment models combine both equity build-up and cash flow growth.  The pre-tax gains from cash flow growth and equity build-up are added together and projected out over a ten year period under a set of modest assumptions about property, rent, and expense appreciation.  The resultant total return on investment (ROI) is then expressed as a compound annual growth rate, or CAGR.  The ROI CAGR is the best single metric for judging the investment potential of an individual property and it can be used to compare real estate investment returns to other investment classes, such as equities (stocks). 

It is important to investment properties that combine appreciation and equity build-up with cash flow growth.  Properties must be selected with very strict and specific criteria relating to property appreciation potential, cash flow growth, and risk.  Investors should be able to always realize positive cash flow with a 20% down payment, even after expenses related to vacancy, repairs and maintenance, property management fees, taxes, insurance, and mortgage payments.  It is important for investors to choose structurally and cosmetically sound properties, obtain excellent tenants, and use a professional property manager.  

Investing in recent years has certainly not been easy.  Fortunately, real estate, especially single family properties, has been and is projected to provide some of the best risk-adjusted returns available to investors, and should be a central part of an investor’s portfolio diversification strategy.