“I’ve Got Money Problems”
Such was the title of a post in the BiggerPockets Forums from a few weeks ago. I contributed to the post, but I think that this conversation is worthy of wider exposure because it goes to the core of our Vision and Perspective relative to the business of Real Estate Investing. With the author’s consent I will explore the answer I provided in the forum to a greater extent in this article.
The following question was posted
(I edited it very lightly):
“I purchased a house for 57k 13 months ago. I put around $25k into it (labor and materials) and rented it out for $1,275. The house was appraised 2 weeks ago at 125k. I am trying to get as much cash out of it as possible and found a lender that can do 70% cash out refinance on a rental property. Net cash out would be around 80k.
There is nothing available for under 80k these days. Properties that are available cash flow very little at around $1,100/mont rent. So:
1. Do I cash out and put the money into the stock market?
2. Do I pay down my other 6-7 mortgages that have balances between 35k-122k and APR of between 4-5.875%?
3. Do I wait for the winter and hope that the prices will drop (unlikely). “
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We invest in income-producing real estate for one of three reasons (and preferably all three):
- To create passive Stable Cash Flow
- To protect the buying power of our wealth by hedging inflation
- To create additional wealth buy outpacing inflation
With this in mind, the following statement is one of the most important truisms in all of investing:
In order to achieve our objectives, we must control the Largest Investment Base possible!
1. Stable Passive Cash Flow
While it is a bit counter-intuitive, buy controlling the largest asset base possible we are effectively diversifying our income buy creating multiple income streams. The old adage of Don’t put all your eggs in one basket applies here.
While a lot of people perceive it as risky to own 10 units, because there are 10 furnaces, 10 sets of plumbing, 10 sets of windows, etc., I believe that being in control of 10 revenue streams is better than one any day of the week! What do you think?
2. Protect the buying power of our wealth by hedging inflation
Inflation is the act of inflating or expanding something. In terms of currency, inflation occurs when through the government’s monetary policy, currency is added into circulation – this is called monetary inflation. When people talk about the government printing money, this is what they mean.
In simple terms, our economy can be explained as units of currency chasing units of goods and services. If the number of units of currency in circulation increases (monetary inflation) while the amount of goods and services available for purchase stays the same, all of those goods and services become more expensive, causing what is known as price inflation. Thus, monetary inflation always leads to price inflation, which is the reason why currency is a metric of relative value. It is why a loaf of bread, a steak, a pound of Colby cheese, and a pound of sugar cost so much less 30 years ago than they do today.
I am not an economist, but I believe that in the United States we have had average price inflation in the range of 3% for the past 80 years, please correct me if I am wrong on this. In fact, one of the stated responsibilities of the FED is to put forth monetary policy which accommodates stable growth in the economy, and something in the range of 3% is considered optimal.
Translation – we will have inflation until and unless our entire economic and monetary systems collapse…
What Does This Mean?
This means several things:
- You need to earn at least as much interest on your money as current inflation level and cost of earning this interest combined to break even. If you put 10k in the bank at 3% interest, you will earn $300 in the first year. Thus, you will have $10,300 to spend. However, if price inflation is 3% then the same stuff that cost you 10k last years is now going to set you back $10,300. Therefore, having earned the interest you really haven’t gained any buying power. What’s worse is that having earned the interest you will have to pay taxes on the gain before you can spend the money. This means that effectively you must earn about 4.5% of interest just to break even – Ouch!
- This also means that in order to win at this game you do not need to be a genius generating 30% returns year after year – this would be nice, but it’s not necessary. All you have to do is beat inflation and cost of doing business by 2 or 3 percentage points over 15 or 20 years! Sounds easy? While for us full-time sophisticated investors it certainly is easy, for most retail people it is a trick…
- Question: Suppose your investments generate 20% total return over the course of 10 years. In this case, would you rather control $100,000 investment base, or $1,000,000?
Answer: 20% of 100k would yield a total return of $20,000 / 20% of $1,000,000 would yield $200,000
Coming Back to the Original Question
My suggestion on the forum was to stop looking at SFR that he could purchase for cash, and leverage the available after refinance $80,000 into acquisition of a multiplex. All things being equal, at 70% LTV (Loan to Value) it would be possible to finance about $185,000 and purchase a building for $265,000. In my neck of the woods this easily buys 6 units. However, even 4 units would be sufficient to make the strategy work!
Having financed the down-payment out of the SFR and financed the rest against the new acquisition, the deal becomes 100% financed. The multiplex, if bought correctly, will most certainly throw off much more cash flow than a SFR ever could; it would diversify the portfolio with multiple revenue streams; and it would give the owner control (with 100% OPM) of a much larger asset base, which is a great thing – especially now when we are staring at very significant probability of inflation…
Now – the MLS may not be the best place to look for a deal like this, but let’s leave that for another day 🙂
What would you do if you had $80,000 to burn?
Photo: 401(K) 2012