Real Estate Investor · Greensboro, NC · Member since 2008 · 6 posts · 0 votes
Seems like there are two methods which all the books, videos and articles put forth: Cash Flow and Appreciation.
Landlording seems to lend itself to the Cash Flow side of things, with possible returns several years down the road when the property has appreciated.
So take this property that I'm looking at as an example:
4-unit apartment selling for $209,900.
Currently fully rented for $580 each unit.
Now, I'm a newbie, and if I'm doing the calculations right, this seems like a good deal with some real cash flow.
But I can't help but get caught up with the part that I need to plunk down $40k plus closing costs just to get into the deal.
So I am tying up my $50k to get about $1,200 per month, or about $15,000 per year. So I don't even get my original $50k back for over 3 years.
Now, the first 3 years I will be building equity in the property that really my tenants will be paying for, as well as some cash flow. After that 3 years, I could either sell it and take the profit or keep it and continue getting cash flow for as long as I own and maintain the property?
Is this the proper way to be evaluating a potential deal?
I'd appreciate any feedback, especially if you are good at more complicated calculations like ROI and the TVM.. things which make my head hurt!
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
I just thought I would chime in here about where the returns in re come from. It is such an easy thing to solve the argument on. Its all about numbers and being a math and economics major, numbers are what I do.
So we do have to make one assumption, the property is bought at fair market value. Buying at a discount comes down to the skill of the investor and has nothing to do with where your returns come from.
I also have to point out that using appreciation rates for the past 59 years actually has no relevence unless you are holding the property for 59 years. There is a way to get an estimate for 5 year appreciation rates but it gets quite complex and isn't really worth the time for this argument. Not to mention using a constant appreciation rate also is statistically incorrect. You have to use a geometric average (what mikeoh refered to about 50% loss takes 100% return to equal).
So here we go. I only have data for 40 years so that is what I will use. It actually works out in favor of appreciation buffs.
So we are buying a property with a fair market value of 100k and we are putting 20k down.
We will start with appreciation. The average appreciation for my 40 years is 6.37%. But the geometric average is 6.32%. Now we must show the real rate of return. The average inflation over the same 40 years was 4.7%, and the geometric average was 4.66%. In order to find real rate of return we take
1+r = [1 + Nominal rate (N)] / [(1 + i)]
so we get 1+r = 1.0632/1.0466 = 1.0159 -1 = 1.59% return for appreciation per year.
Now lets look at principle pay dow. With 20k down on 100k property and 7% interest we have a 5 year paydown of 4695. Which is 23.475% coc. Divide by 5 ( not completely accurate but close enough) we get 4.695%. Using the same formula for real return above we get a 0.0334% percent return.
Lets use Rich's argument above for taxes because honostly I don't know how much is saved on taxes. If you are living off of cash flow you don't get them but if you work you will save 1k per year. So 1000/20000 = 5% nominal return. Solving for real return we get 0.29%.
Now lastly we must look at cash flow. Mikeoh basis his analysis on 50% expenses and he looks for properties that will cash flow 100 with 0 down. On our 100k property he wouldn't buy it unless it rented for 1530.60 per month. 1530.60 x 0.5 - 100 cash flow. Leftover is 665.30 which is payment for 30 year 100k loan at 7%. At 20k down payment we only have a paymetn of 532.24 adding 133.06 to our 100 cash flow for a total monthly cash flow of 233.06. Yearly cf is 2796.72. Annual return on cash flow is 2796.72/20000 = 13.98% Solving for real return we get 8.86%.
So to recap, on a 100k property with 20k down at 7% loan we get our REAL returns as follows:
Seems like a no brainer to me. Aprreciation and tax savings earn 1.88% real return, cash flow earns 8.86% real return.
As far as I can tell, the only way appreciation + tax savings can beet cash flow is if it has a nominal return of 14%. Since tax savings isn't going to increase any time soon, we need nominal appreciation of 9%. Considering your are trying to earn more appreciation than the s average, I would say that this IS speculation, same as trying to pick an individual stock that will beat the market IS speculation.
If I am wrong with my math please correct me, but I must say, I'm not wrong very often and math doesn't lie.
Real Estate Consultant · Member since 2008 · 792 posts · 30 votes
17y
"cash flow vs apprecition argument is amateur" Come on! The initial post in this thread was regarding exactly that and it was the posters'6th post. Evidently, he was interested in contrasting views and that was what he got.
Rich,
That's my point. I believe it is an elementary (or amateur) question, not a bad one. In my opinion, amateurs get lured into buying for appreciation.
It is very easy to underestimate expenses and overestimate the "upside". It's natural.
If you are planning for the upside of "appreciation", you better be planning to buy and hold for a looooong time. The 4-5% average appreciation is spread over a long time. During that spread of time, there are periods in which real estate values decline. So, if you are buying for "appreciation" over less than say 15 years, you are "market timer".
Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y
Mike. I also generate a nice retirement out of real estate cash flow, but newbies don't and neither did I and probably not you in the beginning
2. The cash flow from older properties is fine but they do not offer much appreciation, are very difficult to finance and give little in tax benefits due to land being the largest % of the value
3.I'd like to know how you use "bank financing" on older properties, with a limit of 4 mortgaged properties. A heloc only goes so far in buying.
4. If you're not playing the terms game, imo, you're leaving a beneficial piece out--that would help offset tax consequences.
5.I question your last 2 responses.
You get tax benefits if you buy a good deal and if you buy a bad deal, so that is not an issue.
Not completely true. If your "cash flow"outweighs your depr, no tax benefits, hence my reason for buying properties on terms, HIGHLY LEVERAGED" or Go Zone property for bonus depreciation.
6.no depreciation left per se because of age and nearly no tax benefits.
Again, not the entire story. Only properties 4 units or less receive the 27 years, 4 or more units are commercial and I believe it is 39 years.The other part to consider is age of property. As a property ages the assessed value rises(normally in total) but the Depreciable portion(improvement ) decreases in comparison to land value, which increases. Youreceive very little tax benefits as properties get old. That is just a fact.
Why would anyone buy a rental property that has no cash flow when they could work a little harder (buy at a bigger disount) and have one that has more equity and cash flow?
There are actually investors that could care less about the cash flow. They're in it for the long run and already making gobs of taxable income. To them, a good deal is one that breaks even currently, newer in condition for maximum appreciation and tax benefits. A cash flow older mobile home park would do them an injustice. One size doesn't fit all.
I've always advocated not selling property almost forever. Now with more difficult financing scenarios, times are changing. New rules, but same game.
My business model is this.
1. Own lots of F&C properties to provide adaquate income to support the lifestyle of my wife.
2. To own lots of properties mortgaged to the hilt for tax writeoff.
3. To file a tax return every year and pay ZERO in taxes.
4. To help educate others to do the same
I'm not peddling anything and offer answers to all who ask, at no cost.
Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
17y
Lance, I'll assume that your math is correct. To tell the truth, I didn't even look at it that carefully, because the assumption that you used is wrong and therefore all the data associated with that assumption is wrong.
In almost every market, a property bought at market value (retail) will not cash flow with 100% financing (or with any other percentage of financing when you count the opportunity cost of the downpayment). Let's take your example of a house with a market value of $100,000. There is NO WAY that I would pay $100,000 for that house. In fact, in today's market, I wouldn't pay a penny over $50,000 for it (if it didn't need any rehab).
I have purchased the vast majority of my property without any of my own money (but with a very low LTV). My return on those properties is INFINITE.
Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
17y
One more thing. When I buy a $100,000 property for $50,000, I don't have to wait for the property to appreciation. I've essentially got 100% appreciation at purchase! I'll take mine now, thank you!
Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y
Crap!! Mike and Rich agree. Couple other points
So we are buying a property with a fair market value of 100k and we are putting 20k down.
Until recently, not many investors put 20% down. Leverage was and still is the name of the game to me.
Also the appreciation becomes a much higher % of return at 5 -10% down. Many years the appreciation was 100% based on down. , on papre 5% dn and 6.34% would really skew your #'s
Also, someone would be saving a lot more on taxes as a % of investment.
I never graduated, so your info was complicated to me, but I think my points are corect.
Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
17y
Couple things I would like to point out here:
1. I noticed on the appreciation calculation, you made sure you added in inflation, but did not do so on cash flow. Is that entirely fair for your argument?
2. After the inflation, your posted annualized return is quoted at 1.59%. What you failed to mention is that is based on the entire 100k property, but we only put down 1/5 for the cash invested, so the return she be multiplied by 5 to be entirely fair which equals 7.95%
Lastly, IMHO, I also stand by my thought process and startegy that residential investments, on an individual basis, offer more net worth building and tax deductions over time than cash flow, However, I also believe cash flow is very important. I just do not think that it should be leaned on to survive.
Now if we switched the conversation to commercial properties, then cash flow becomes much more relevant and substantial. This is not to say that appreciation is no where to be found, as you can also force appreciate, but to say that cash flow is a much higher component in that type of investment.
To add, I agree with some of Mike's assessments as buying correctly is important, but not everyone lives in an area where you can pick up properties for 50%. Try that in CA, and even if you did, you still would probably be lucky just to break even on cash flow.
One last thing for Lance:
Why does the last 59 years have no relevance but the last 40 years does in your example? Why the discrepancy, so I can understand that point? You did not use in your example that the subkect property would be held for 40 years.
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
Sorry everyone,
I need to make a correction on my math.
The real appreciation rate is 1.59% on 100k. Since we are leverageing, the property will be worth 108206.86 in real dollars in 5 years. That is 8206.86/20000 = 41.03% return for 5 years. 1.4103^(1/5) gives us annual leveraged real return of 7.12% from appreciation.
7.12% appreciation
0.29% tax savings.
Total of 7.41% from buying from appreciation. Much higher than I previously stated but, Still not the 8.86% return from cash flow.
Please show me how the math is wrong Rich, I want to know your argument, but unless you can prove me in numbers I'm going to have a hard time listening.
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
I don't have time right now, I will be back later to restate some arguments, but off the top, I did take inflation out of cash flow, before inflation it was 13.98%.
Also, I assumed buying at fair market because that was the only way to show where your returns come from. Obviously buying at a discount is the highest return. I wanted to look at actual appreciation from one year to the next.
I'll be back
Lance
Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
17y
Thank you for correcting the numbers on appreciation based on the leverage example Lance. Now you need to adjust the cash flow return for inflation as well to be perfectly fair.
Then, a lot of investors, including Mike, by his admission, do not put 20% down, but 5% or 10% (I know sometimes 0%, but we will not go there for this example)
Now calculate appreciation on 10% down and see where we are. 10% down is very common, when you consider that lines of credit or owner seconds are common to obtain this leverage amount.
Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
17y
Lance, forgive me. You did adjust for real return on the cash flow, I missed it and stand corrected.
We are all allowed to be wrong once per year, correct?
Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
17y
Originally posted by Fred S:
this thread is awesome
I agree Fred.
With the exception of the comment that stated that there was a lot of bad information posted, this thread is fun and quite valuable for all reeaders.
There is only difference of opinion and strategies, not bad info here.
Lance posting the mathematics is helping to compare each story more accurately and fairly. As we get closer to agreement on the final figures, we will have some actuals to compare to for the benefit of the analysis.
:D
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
I'm working on different scenarios for money down right now, I'll have them in a few minutes.
Just to explain better the 59 yrs and the 40 yrs that someone asked about.
You were absolutely correct that 40 yrs is no better than 59 when it comes to your holding period. Actually it is worse, but that is just the numbers I have readily available (I'm working on publishing a paper comparing real estate to stock market). But all in all it is close and gives us something to work with.
Also, I fully agree that buying on discount is truly the way to great returns and I wasn't trying to ignore that at all. It will certainly trump everything else. I'm just not accounting for it here because it is based on the skill of the investor. I will do my best to account for it in my next post.
Lance
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
All right everyone, time for me to play and I must say I found the results to be pretty interesting. Just so everyone is aware, I don't own any property, I'm just trying to run the numbers. I'm trying to be as unbiased as I can as I really want to know for myself for when I go to buy properties in the future. Also, as before I am putting everything into 1 year rates of return.
So lets start, using the previous example, looking at a 5 year period, 100k property loans at 7% interest.
Looking at 10000 down. We get FUTURE appreciation: 8206.86/10000 = 82.07%, adjusted for 5 years 12.73%
Cash flow works out 166.55 /month *12 = 1998.36/10000 = 19.98% adjusted for inflation we get 14.64%.
Now to look at buying at a discount, putting 10000 down on a 100k market value property, we must buy it at 88406.14 or 11.59% off of market value in order to achieve the same 14.64% return that cash flow gave us. The problem is, by discounting the property we decrease the loan amount needed and increase the cash flow to 243.66/ month with adjusted return of 23.48%. So appreciation increases by 1.91% and cash flow increases by 8.84%. So the more we discount the property the spread actually gets bigger. Looking at the extreme, lets say our 10000 down actually buys the property. Now appreciation gets us (90k + 8206.86)/10000 = 982.07% 5 year. one year =61.01% return on 10000.
Now the cash flow becomes 765.50*12=7986/10000=91.86% adjusted for inflation gives us 83.32%.
I'm not sure if these numbers cross at any point, but it appears that nomatter what the discount is cash flow wins in a 5 year period with 10k down.
Now we look at 5000 down. Future appreciation is 8206.86/5000 = 164.14% for 5 years or 21.44% annual return.
Now cash flow is 133.26 *12 = 1599.12/5000 = 31.98% adjusted for inflation gives us 26.10% return.
Now again for the discount, in order to get the 26.10% return of cash flow we need to buy at a 2.735% discount. Now our yearly cash flow increases to 1817.52/5000 = 36.35% or 30.28% adjusted. If 5k buys the whole property we have 84.95% for appreciation return, and cf is 9183.60/5000=183.67% and 171.04% adjusted.
Now look at 0 down ($1 just so we can have something other than infinity)
Appreciation gives us 8206.86/1 = 820686% and 506.52% adjusted for 1 year vs 5.
Cash flow is 1200/1 =120000% adjsuted to 114652.53% for inflation.
Interestingly, there is no way to discount the price enough to have that same rate of return. If we are given the property for free we have a 10820686% 5 year return, but breaking that down to 1 year we only have a 1015.90% return.
As an overview, nomatter how I skew the numbers, if you find a 100k property that cash flows 100 with 0 down, appreciation will never have a higher return than cash flow.
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
I forgot to add in that in fairness, this is based on a 5 year holding period. Buying at a discount will have a much higher return if we sell after one year. Not looking at the discount, cash flow will always win, if we include the discount then the shorter the term we hold the property for the higher the appreciation return. As the holding period increases this return (broken down to yearly) becomes less and less of a factor and by 5 years cash flow is king again.
Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y
Lance, this is too confusing. How about just answering this.
If I buy a property for $100K with 5K down(forget closing costs at 7% for 30 years that breaks even exactly. My pi will be $632.
I buy same house and want $100 cash flow per month on this same deal at same interest rate of 7%, I'll need to put down an extra 16K.
Use the same 6.34% annual appreciation rate.
Don't worry about the principal reduction or the tax benefits for highly leverage property.
In 1 year, my 5% down property on paper is worth $106,340. my return on the 5K investment the first year is 127%. My 5K grew to $11,340.
On second scenario I invested 21K.(additional 16K to get the $100 mo.) I made the same $6340 plus the $1200 in cash flow for a total of $7540.
My investment was $21000 total to get the $7540. To me, that looks like a return on my investment of 36%.
I used same property, int rate, length of time etc. If in the second year I make another 6.34% on NO additional investment, my return is still greater. Even if you increase the rent periodically, you'll never catch the scenario 2,,, on paper.
If I added in the tax savings on highly leveraged property, and the taxes you might owe on the cash flow, it would be even higher than the example.
I'm not saying I don't like cash flow, just that it is NOT where you create wealth in Real estate over the long run.
Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y
I can only defend my post, I don't understand a lot of Lances' figures. My 6.34% was from the following article according to Natl Assn Of Realtors.1968 -2004. NATIONALLY......your area may differ.
http://www.realestateabc.com/graphs/natlmedian.htm
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
Haha, ya I get lost myself when I try to follow my own post! 6.43% appreciation has been the national average over the past 40 years.
I'm just trying to put everything in equivalent terms by setting everything at a 1 year return on your cash and then adjusting for inflation.
As far as your example goes Rich, I did some more calculations to figure everything out. Yes you will get a much higher return from appreciation if you are buying your cash flow. In the previous math I was just looking at one investment that made cash flow and appreciation and figuring out where the higher returns came from.
In your example, essentially when an investor is buying cash flow they are trying to lower there risk. Everyone knows the lower the risk, the lower the return. Fortunately, we have a way to measure risk called standard deviation, it uses the returns you recieve compared to risk free rate of return (t-bills). I went through and computed everything in excel, and it does work out that putting less down and not getting cash flow is quite a bit more risky. There is also a way to take individuals opinion of risk out of the equation, it is called the sharpe ratio and it basically shows how much every unit of risk is costing you.
In this case, putting less down gets 1.064 and getting cash flow gets 1.036. The higher the number the better investment it is.
So as far as the argument about whether people should put more down to achieve cash flow, you are right they should not. In this case the risk is worth it.
This also doesn't take into account the cost of capital which would make your argument stronger.
So all in all, I'm concluding that on an investment that earns cash flow and appreciates, the cash flow will earn a higher rate, but it is not worth it to buy cash flow by putting more money down.
Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y
I think I got that. If you're not disputing my #'s, it is a slam dunk and always will be. Long term creation of wealth is easier if you own more property, reduce your taxes to Zero and let the tenant pay off your loan for you. Pretty simple imo. Thanks Lance. I feel like going out and buying some more!!!
Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
17y
I guess I don't even understand this comment. Every single property that I have cash flows. I would not buy anything that doesn't make money. The ONLY reason that I'm in business is to make money.
I don't have any properties where the land value is the largest part of the value of the property. I have not had any trouble financing any of my properties and I've never heard any bank say anything about the age. As I said, my oldest property was built in 1835 and the newest 1998.
All of my properties were bought directly by my LLCs, with me signing personally, of course. There is no limit on the number of commercial loans you can have.
I would never pay more for a property to get better terms. That means giving up equity and I won't buy a property without plenty of equity.
I certainly would not try to lose money just for the tax benefits, especially if you're in a low tax bracket. Would you really turn down a dollar just to save 15 cents in taxes?
I'm not a tax expert and I don't play one on the internet. However, I just pulled one of my tax returns. The depreciation is listed on IRS Form 4562. My apartment buildings are listed under "residential rental property" and are depreciated over 27.5 years. The 39 year depreciation is for "non-residential real property".
Why would anyone buy a rental property that has no cash flow when they could work a little harder (buy at a bigger disount) and have one that has more equity and cash flow?
I agree, I've looked at a lot of apartment complexes and every single one of them is a money pit. Tax benefits are the only thing you could hope to achieve with these properties.
My business model is this.
1. Own lots of F&C properties to provide adaquate income to support the lifestyle of my wife.
2. To own lots of properties mortgaged to the hilt for tax writeoff.
3. To file a tax return every year and pay ZERO in taxes.
That is very similar to mine, except all but 2 of my properties have mortgages (debt) on them (with a low LTV). My goal is to pay them all off, collect a much bigger cash flow and pay the taxes on the income (unless I can find a way to legally shelter it).
Real Estate Investor · Woodbury, MN · Member since 2008 · 133 posts · 43 votes
17y
There is obviously a lot more that can be put into the equations, but overall I think it is goin to stay the same, unless you are severely risk averse, you are better off to buy properties with less down and break even cash flow.
Or better yet, buy properties at a big enough discount so they cash flow with out putting any extra down, this is where the ultimate returns will come from, and I don't care if they are coming from appreciation or cash flow as long as they are making me RICH!!!!!