Real Estate Investing: Cash Flow or Capital Gains

I encountered an interesting scenario tonight when I read a question posted on biggerpockets.com(a real estate investing site) by Kevin Kaczmarek. Kevin wrote a post giving two ways to purchase the same home for investment. The fun part is reading the comments, mostly from investors and wannabe investors (anxious to get started), who’ll be choosing whether to pay $36,000 cash, or $50,000 with owner financing, on a house valued at $75,000.

Jeff “Bawldguy” brown posted a great response to the question on his own blog.(http://www.bawldguy.com)

Jeff said “Many, if not most, will be as sure as Monday follows Sunday that one or the other is obviously the superior approach. Purely by the numbers, I can argue both methods of purchase, might be the case for you. But, just for kicks ‘n giggles, let’s ask some questions. First though a review of sorts.

BawldGuy Axiom: It’s not finding the answers to all the questions you have that’s the problem. It’s the answers to the questions you never knew to ask that end up bitin’ you on the butt.”

Jeff went on to propose a few questions such as “how old is the buyer?” and “how much money does the buyer make per month.”

I completely agree with Jeff. There are too many scenarios(big pictures) given the question to determine a “right” or “wrong” answer. But I’ll will tell you what I would do in most situations, with the disclaimer that situations vary and no 2 cases are exactly the same.

MY TAKE:

Either way the proposed situation is a slam dunk, can’t-lose deal to any real investor..

Initially most people are going to think “flip” when they hear a value of $75,000 and a price of $36,000. But professional real estate investing is about more than just getting lucky and finding a property at less than 50% of it’s value…

Assuming you did however find a property that was truly worth $75,000 and you could buy for $36,000 cash. And assuming you had the $36,000 cash. I would not recommend buying the property cash and flipping it.

Here’s why:

With what we are given in the scenario, the buyer is obviously not struggling to survive in life(They have $36,000 cash). So they don’t HAVE to flip.

Flipping would mean being taxed at a capital gains rate, which is less than earned income but significantly more than passive income.

The example says the property needs $10,000 to sell at it’s fair market value of $75,000. That means you will still need another $10,000. Now you are into the property $46,000. Assuming there is no hold time to sit on the property and assuming that you get a full price offer of $75,000, you are left with a gross profit of $23,750.

Ah, but then there’s taxes

Since the person in the scenario has $46,000 in savings, I am going to make a safe assumption that they are in the 30% tax bracket. Now thy are only left with $14,210.

$14,210 is not a pad pay day.

But real estate investing is a wealth strategy. You flip to make money, you hold to build wealth.

The author of the example says you can purchase the house with seller financing for $50,000 at 6% interest rate paying $299.78 per month in principle and interest until paid in full. We can assume each month you have to escrow $200 for taxes and insurance and the property will gross $950 a month in rent. Finally, the property is in a growing neighborhood with new businesses moving in and a college expanding enrollment. Homeownership and the rental market are in demand.”

Again, this is just a slam dunk walk in the park deal, especially since based on the author’s numbers, this strategy would be FREE!!

Here’s my professional answer:

Take the house on owner financing for $50,000. Assuming their is an additional charge(with the author left out) of property management, we’ll assume the property will have expenses of $300 per month, instead of $200. This is still a net cash flow return of $650 per month.

I would “rent-to-own” the house to someone else. By doing this I would make an absolute minimum of $5,000 from a down payment from my new tenants(Who would also be incentivised to maintain and maintain the property -

After one year, the cash on cash return is an infinite return, because there was no money used by the investor to buy the property. The investor now has $12,800 in his pocket($5,000 down plus $650 cash flow x 12 months.

Right here we are within $1,500 of the net return that “flipping” the property would bring. But now let’s factor in taxes.

Since the property has a mortgage, the investor is writing off that interest. He is also writing off expenses such as property management. Other tax advantages associated with the property would be depreciation.. The tax rate of the income received as rent would be much less than from flipping because it is considered passive income when earned from rent.

Also, the investor still owns the property! So he is going to keep making that $650 for as long as he owns the property. Not too mention the author said , “the property is in a growing neighborhood with new businesses moving in and a college expanding enrollment. Homeownership and the rental market are in demand.”

This means that the rent will be increased in the future should the current tenant not perform on their option to purchase the property later. If they do not perform on the option to buy, the investor can put the home on the market again as a “rent-to-own” and get another quick $5,000.

Really a simpler question the author could have asked to any real investor is, “Would you rather have $14,000 now or $5,000 now plus a minimum $650 per month forever?”

PS: Choosing the option to buy the property using owner financing for $50,000, the buyer would still have his $45,000. So he could go put $15,000 down on 3 more properties valued at $50,000 and rent them out for more cash flow. Plus he could re-finance all of his properties in the future to leverage to buy more cash-flowin