Is this scenario realistic?
I put the following tirade together to show my friend how real estate beats the market (equities, stocks). The scenario below is the actual property I purchased last year. Please let me know if I'm off on my assumptions.
I purchased a 6-unit multifamily property for $1.5 million with 10% cash down ($150,000 cash including closing costs). I now have a fixed mortgage for 30 years, at 6%. My monthly mortgage is $8,100 and my rental income is $9,500. To be fair, I should deduct 5% for vacancy AND 5% for future renovation/maintenance/upkeep – bringing the income to $8,575/mo. Then I must deduct all property taxes, water/sewer fees and liability/hazard/fire/flood/hurricane insurance. My net income is now $7,875/mo. After paying the $8,100/mo mortgage I now have a negative $225/mo cash flow.
Now the tax benefits… Let’s say I am a wash on income and expenses. But I can still depreciate the building; in this case the building is worth $600,000. Over 27.5 years this comes to $21,800/year. I can then reduce my taxable income by $21,800/year. In the 30% tax bracket, that’s $6,540 in taxes I save every year. Or $545/mo, which wipes out the $225/mo negative and puts me in positive after-tax cash flow territory ($320/mo positive). Sure rents can drop. But as long as the rents are not inflated (like how they were in SF during the internet boom years), they generally increase at 2-4% year without a whole lot of up or downswings.
So now you see how the property has become sustainable on its own. You see that I have allocated enough to cover the expenses including maintenance and upkeep, and insurance to make sure the asset is protected (can’t insure a stock, can you?), and still cover the mortgage.
But now let’s talk about the gravy. Considering a 30 year mortgage, you are contributing every month to the equity in your property at a rate of 2.34%. That’s on top of any real appreciation on your property. That means that from the first year to the 30th year, you are annually adding 2.34% compounded to your investment. How does this work? Well if you take the outstanding mortgage of $1,350,000 from the first day (and you own none of that), it would take exactly 30 years to pay it off. But you’ve just made $1,350,000 – buy just paying your mortgage down. This 2.34% is in addition to the appreciation in home value.. If the “normal” long term real property appreciation rate is 5%, and you are paying down a 30 year mortgage (and do not have an after-tax negative cash flow) your real rate of appreciation is 5% + 2.34% = 7.34%. Not bad? Well, it gets better.
Let’s consider that $320/mo in positive cash flow and put that in an investment – whatever that may be. And let’s say that returns 8% (the standard that I see everyone use). Well, $3840/year, every year invested in an account yields $125,000 in 15 years and $508,000 in 30 years.
OK, but how will inflation affect your bottom line. Well inflation is your friend in real estate. YOUR BIG FRIEND. Inflation increases the cost of everything, including maintenance, upkeep, insurance, taxes, sewer fees, etc. But this usually represents a small portion of your monthly costs when taking into account the mortgage (which is fixed for the life of the loan). But inflation increases RENT. So if we consider a modest 3% inflation rate, your rental income will increase by $3,420/year in the second year, $3,522 in the third year, $3,628 in the fourth year and $3,738 in the 5th year so forth and so on. So as you can see, the increase starts off at about $3,400 and compounds at 3% on that amount every year. So now you have $3,400 MORE to invest every year after the first year (the $3,400 actually grows by 3% every year but I’m not sure how to compound the difference) In 15 years that’s another $110,000 and in 30 years $450,000 at 8% yield. But to be fair, you have to consider increases in other non-fixed costs. In this case, we are talking about $780/year at 4% (insurance, property taxes and sewer fees always seems to outpace the general rate of inflation). So we can subtract $40,000 from the $450,000 yielding $410,000.
So now lets recap what happens in 30 years… So you realize only 4% appreciation in your real estate value. Your $150,000 cash down has given you in 30 years –
$3,365,000 (4% annual appreciation)
$1,500,000 (2.34% annual “appreciation OR principal paid down on loan, however you want to look at it)
$508,000 (after-tax cash flow invested annually into 8% annual yield account, whatever that is)
$410,000 (increase in rents minus increase in variable operating costs invested annually into 8% annual yield account, whatever that is)
Total gain - $5,783,000 or 12.9% compounded annual yield on the $150,000 investment.
And these are based on conservative numbers – 3% annual rental increase, 4% annual increase in operating costs, and 4% annual home appreciation. Add just 1% to the annual home appreciation (the long term industry standard of 5%), and your total gain is $7,400,000. Conversely, if annual appreciation is well below the standard – 3%, your total gain is $4,558,000. But this is still a respectable 12% annual gain. Not bad huh? Of course, there are a TON of variables that can come into play. And I am managing the property myself (just finding tenants and collecting rent checks, I have a property manager take care of issues on site) so there is work involved. Maybe your tax benefits will be better, or worse. Maybe you’ll have bad tenants that don’t pay rent and have a higher vacancy rate than 5%. But you may also have great tenants that pay rent and a low vacancy rate of 2%. You may realize 7% appreciation or 2% appreciation over the 30 years. The above scenario provides an average look, if not a conservative one on real estate investing. If you want to make money in 2-5 years, stay away from real estate. Corrections can last 10 years or more. While unlikely, your property could lose 30% of its value in 2-5 years. But like any long term investment, you have to be able to ride the rollercoaster. And if you want a “set it and forget it” investment, steer clear of real estate. You will be a very stressed out, unhappy individual, any way the market goes. If you can stick it out for the long term, nothing beats real estate. Nothing even comes close.