Need advice on investment property
The Woodlands, TX · Member since 2013 · 18 posts · 29 votes
Just starting out here...
Have $50,000 to invest in real estate.
Would you:
A) Buy one Condo / Apartment outright (paid in full) and rent it out
or
B) Mortgage two Condo / Apartment's (either 15 or 30 year) and put $25,000 as a down for each
I am leaning towards the first option.
Help me understand the pro's / con's of these choices.
Thanks
Apologies for being far from an expert on this, but the conventional wisdom is that, all else being equal, more properties is the better play. In general, cash is king, and you want to use as little of it as possible to generate a positive cash flow return.
Let's look at your example, and make some assumptions, and then tack some numbers on there. We have two identical 2/1 condos, each with a 50k purchase price, where each rents for $750/month. For simplicity's sake let's ignore the soft costs like closing, title, and inspection.
Scenario 1: You spend your 50k on buying one of them outright, and your gross income is $9000/yr (750*12). Cashflow is $375/month or $4500/yr (50% rule says that half of your gross income can be expected to go towards your non-mortgage expenses, such as maintenance/vacancies/management/capex/utilities/etc). Your cash on cash return (the money you get back vs. what you put in) is $4500/$50000, or 9%. Fair, I suppose, but let's look at scenario 2.
Scenario 2: You spend 50k to put 25k down on both condos, meaning you're financing the other 50%. Your expenses are doubled (two units), but so is the rental income. The added variable is debt servicing. Again, with numbers. Gross Income is 18k/yr (2*750*12). Expenses are $9000/yr (50% rule). Leftover is profit of 9k, but you still have to pay the mortgage. I plugged financing 50k at 5.25% over 30 years into a mortgage calculator and got payments of 275/mo, which is the total debt servicing on both units. So 9k - (275*12) = $5700 yearly cashflow. Better! And your cash on cash return is 5700/50000, or 11.4%. Better there are well.
The thing to understand is that your best cashflow is going to be on a property that's paid off, but it's artificial, because you have to put more cash into it to force that return. Cash that's tied up in rentals is cash that can't be used to buy more rentals.
Suppose we take it even further (why not?!) with scenario 3: 4 condos, each listed for 50k and with that same 750/mo rent. You put 25% down on each (for a total cash outlay of that same 50k), and finance the remainder. Gross income is 36k/yr (4*750*12), and expenses are 18k/yr (50% rule). Leftover profit (called Net Operating Income) of 18k/yr. Now subtract the debt servicing (financing 150k @5.25%: $830/mo*12months= $9960/yr) and you're left with a yearly cashflow of $8040. Best yet! And your cash on cash goes to 8040/50000, or 16%!
Now, there's no question that, from a mathematical standpoint, the less you spend on a property that cash flows the better your return on investment is. But there are other expenses involved in buying multiple properties all at once, most notably the soft costs I ignored earlier (closing costs, inspections, etc). This is why people love multifamily rentals, because you get the benefit of the improved return with only one transaction.
Hope that helps!
You also do some hand-wavey math when saying, in example one, you could cover the rent for all six houses without it being an issue, but in example two covering the rent for only four (1/3 of 12) would dip into your (greater than example one's) profit. Not quite sure of the logic behind that one.
Leverage, as I understand it, is primarily about your risk tolerance. On the one hand, if you own more properties, you're more protected from a nightmare scenario at any one of them. Basically, it's a form of dollar cost averaging for owning rentals. That said, your capitals expenses can be way higher. Lots more roofs, HVAC systems, and plumbing than if you just own one property. Again, though, this expense is accounted for in the 50% rule (and, if you're actually buying, your due diligence calculations), so if you are careful with your buying you should be covered.
The argument BUT YOUR EXPENSES ARE WAY MORE! is spurious, because YOUR INCOME IS WAY MORE TOO!
It seems like where people have been burned on leverage is either (1) when the market crashes and the properties are suddenly not worth what you owe, or (2) not buying each individual property very carefully. Both of those dangers are present when you buy cash, in smaller doses. For instance, if you own a SFR free and clear and the market tanks, there may suddenly be a glut of rentals out there undercutting you, meaning you can't fill your rental. The bank doesn't take it away from you, but since there are carrying costs it's cash flow negative. If you don't come out of pocket to pay those costs you'll lose the property. If you paid cash betting on appreciation and you don't get it, same potential issue. You're stuck with a place that is costing you money. It's just less money than if you financed 10 of them. So, again, it's about risk tolerance, and (IMO) it's a difference of degree; not kind.
Time is never 0 when dealing in real estate. Management companies need to be managed.
True, but that wasn't the argument. And managing the PMs take roughly the same time whether they have 2 properties of yours or 20, so it still doesn't change your effort significantly.
Even if you have the most outstandingly wonderful property manager in the world, your time spent on these will never, ever be zero. And no matter how minimal your time spent on each one, you will spend more collective time as your holdings increase.
Only the late night infomercial gurus claim real estate investing is 100% hands off.
Opinions on leverage are much like opinions on religion. Ultimately, we are going to have to agree to disagree.
Some prefer the Trump model where you leverage when needed but keep that leverage compartmentalized.
Some prefer the Kiyosaki model where you leverage across the board as much as possible with no compartmentalization.
Just comparing the overall results of the two JUST in real estate tells me everything I need to know. :)
And for the record, I am not a Trump University attendee. Just because I think the business model he used to accumulate his real estate holdings is sound does not mean I buy into his hype as a guru.
Even if you have the most outstandingly wonderful property manager in the world, your time spent on these will never, ever be zero. And no matter how minimal your time spent on each one, you will spend more collective time as your holdings increase.
Indeed. Just nowhere near the time you estimated. And when compared to the extra income, it's usually pretty profitable time/hr (I would speculate).
First Thank you for the very interesting discussion on how real estate investors should approach risk, and what he/she is comfortable with.
I think what both of you are saying is that likelihood (or probability) is less when you are not leveraged (fewer units) , The impact could be more severe than if you leveraged and owned more units
Let me quantify
Basis From example above
$300K start with
$50 K houses / Rent $750
Expenses (%50) $375 ( you still have taxes and insurance regardless if you carry a mortgage or not)
Appreciation 5%
Option 1
Buy 6 $50K houses free and clear
Starting equity = (300K value – 0 Loan Balance) = 300K
Income = $750
Expenses (%50) $375
Cash Flow $375
Times 6 units = 2250 Month (same as Mr Duncan Demo)
Option 2
Buy 12 $50K houses ($25K Down, $25K Financed)
Starting equity = (600K value – 300K Loan Balance) = 300K
Income = $750
Expenses (%50) $375
P&I (25K at %5 for 30 years yields monthly payment of $134
Cash Flow $240
Times 12 units =$ 2880 Month
Risk assessment / Management
While the probability of getting a bad tenant is more with the greater # of units, The IMPACT would be less:
Risk Analysis
Hazard : getting a bad tenant that late/skips on rent
Effect: you lose one months rent ($750)
Probability of Incidence (PofI) = in our example 1 in 20 (5%)
Option 1
PofI = 6 units *(.05) = 30% chance
Impact + (-$750 cash flow ) -> Net cash goes from $2250 to (2250-750) $1500 a (%33) decrease
Option 2
PofI - 12 units * .05 = %60 chance you get stuck
Impact = ((-$750) cash flow -> net cash goes from $2880 to (2880 – 750) 2130 = 26% decrease
So while the chance Is greater with multiple units , the impact is lessoned due to the other income streams.
We can take the same line of reasoning when Analyzing other Risk Hazards such as loss of income; loss of property ; (house loses entire value) ;
In addition , I think we need to look at other non cash returns when considering leveraging versus non leveraging, as some of Leveraging benefits don’t show up on the cash flow line
Total return
Calculate total return for scenario sake – assume 25% tax bracket and 5% appreciation
Option 1
Cash 2250 Month * 12 months 27K a year
27K / 300 K = 9% ConC return (as stated)
Other returns
Equity build up = $0 (already %100)
Tax savings (assume 40 K tax basis , 27.5 year amortization )
$1450 per year DEPR allowance * 6 houses = $8700
$8700 DA * .25 (tax rate) = $2175
Appreciation
Appreciation 5% = 50,000* .05 = $2500 year appreciation
2500 * 6 (houses) = $ 15000
Total return = Cash + equity + Taxsavings + Appr
= 27000+0+2175+15000 = $44175
4175/300000 = 14.71 total return
Ending Equity => Value – Liability = ($300K *1.05) – (0) = $315K
Option 2
Cash 2880 Month * 12 months = $ 34,560 a year
34.45K / 300 K = 11.52% CoC return (as stated)
Other returns
Equity build up
Using financing model above (25K financed at 5% over 30 years ) – yields $360 equity build up in year 1
$360*12 houses = $4320 Equity build up
Tax savings (assume 40 K tax basis , 27.5 year amortization )
$1450 per year DEPR allowance * 12 houses = $17400
$17400 DA * .25 (tax rate) = $4350
Appreciation
Appreciation 5% = 50,000* .05 = $2500 year appreciation
2500 * 12 (houses) = $ 30000
Total return = Cash + equity+Taxsavings+ Appr
= 34,560 + 4320 + 4350 + 30000 = $73,320
73,320/300000 = 24.41 total return
Therefore you get more sizeable return on your money for assuming the probability of more risk, even if the impact is lessened
So, if we take out a 30 year conventional mortgage on the Condo with say 15-25K down (rather than buying outright with cash), my only worry would be how this mortgage debt would affect the approval amount of the VA Loan we intend to use for a primary residence.
Dont know if you ever got an answer on this, but I have done similair things in the past ( when PCS i would rent out my old house and buy at the new location) I dont think the loan amount would impact the approval amount as much as the monthly payment, and if you are able to get the condo rented so you can show that income stream. from my experience, VA (and most mortgage lenders) look at monthly income and payments to determmine how much amonth you can afford, and then set the loan amount based on that
@Kenneth Hynes I just met with a realtor via BP yesterday and he told me that banks only consider the income stream from a rental after about 2 years. He said that in some cases, some banks will only need 1 year of rental income. So that would mean Hans would have to manage the property for 1 - 2 years before he could qualify for the VA loan. Unless of course he had a big enough salary that the condo payments were inconsequential. If I am off base, please feel free to correct what I am saying.
By the way, I am faced with a similar question as Hans - how do I best allocate the funds that I have. More houses with higher debt or fewer houses with lower debt. It's an interesting discussion because I would have assumed that maximizing leverage would be the black and white, no brainer answer.