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October 05, 2012

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Apex,

This is a great article and it shows the current potential of real estate investing. The ROI really shows the power of leverage... 9.1% is a very good rate of return but 18.4% is just insanely great.

Although unless you tap the home equity that is building up, wouldn't that 18.4% decrease toward 9.1% as your leverage decreases?


One number I did not see in the costs- compensation for your work managing the property. I don't think it is fair to not include some estimate- as you could be earning other income with that time.

Also, there will come a time at which you will need to hire help to manage additional properties and then it will be a real cost.


-Rick Francis

Rick --

You asked: "Although unless you tap the home equity that is building up, wouldn't that 18.4% decrease toward 9.1% as your leverage decreases?"

Yes. I am looking at these same sorts of numbers and this is exactly what happens.

But if you have a 30-year loan, the decrease takes place over all 30 years, and that's a long, long time.

This is very informative. We are looking into purchasing a bigger house for our growing kids. We are also thinking of either selling this place or have it rented out. This article is definitely a big help in making our decision. Thanks!

association fee is almost half the mortgage?

@Rick,

All very good points.

Yes the returns do decrease over the course of the mortgage if you do not tap any of the equity that builds up. For the first 5 years or so the change is almost unnoticeable. But eventually if the property increases in value and the mortgage balance decreases, tapping the equity is a way to keep the returns higher.

As I mentioned in the article its also important to put the cash flow back into more properties if you want this return to compound. There is another measure of return called Internal Rate of Return (IRR) which accounts for all of these types of things. However it is far more complicated to calculate than the ratios I showed here and I don't think it helps me make any decisions anyway.

Some people think that making a real estate business profitable involves strict attention to the financial details. I disagree. Clearly you have to run numbers and that is what this column is about. But I have never tried to make these decisions by comparing numbers to the nth degree and deciding by having some kind of hard and fast cut off like I must make 16% ROI, or by deciding between properties based strictly on which one produces a higher return on a certain ratio.

The purpose of the numbers in my opinion is to make sure the property will perform well, will have margins of safety and will be a good long term investment. Once you have a handle on these numbers you can pretty much ball park them as soon as you look at a property. You have a sense for them and then you just run the numbers to make sure it still looks good.

As to accounting for labor put in, on a pure external investment basis this is true. However I am not trying to justify my time. I am trying to determine how much of a return I will get on my money. It is true that labor is a part of it so on a pure investment return basis you would have to subtract labor. It's a bit tricky to work that into the numbers because I don't put in much time doing labor and its quite variable. The argument that I could do something else with my time is true but that is an opportunity cost. I don't see returns on stocks discounted by accounting for the opportunity cost of investing them in something else.

The point of these numbers is to show how much will my money grow after I do this and they values here are an exact representation of that. It is understood that I will need to put in some labor to get that growth.

You are also correct that if I get big enough I will need to hire labor and then it is a real cost that will be paid with cash and it will by its vary nature reduce the returns. I do hope to get there some day. I have already thought about the size and numbers I would be talking about. The reduction will likely be pretty small because I can get pretty large before I need to hire help.

Again, I want to say that all your points are very valid. It's just not what I am trying to show with these numbers.

For example some people add in the tax savings to their ROI because they get to reduce some tax payments in ways that other investments do not. I don't do that with these numbers either because I also think that makes things messy and doesn't help for comparing returns. If I buy a stock that goes up 50% I pay no tax on that until I sell it so how do I account for that tax benefit.

My goal with these numbers is to say the following:

I had X dollars of cash that I invested in this business on Jan 1. How many dollars of cash and how much profit including principle paydown will I have on Dec 31. And will those returns be similar for the few years following this one. That's what these numbers show.

What the returns look like 20 years from now is what IRR is for but I am not actually that interested in that. Things are too variable for me to put too much stock in 20 year projections.

@Bob,

Yes the association fee is 40% of the mortgage. And it still makes these kind of numbers. Crazy huh?

I am sure you and maybe others are thinking why on earth is he buying townhouses with that association fee. Why not just buy houses.

Great question. I'm glad you asked. :)

In the area I am buying townhouses were over built in the 90's and 2000's. As such during the housing crisis tons of them were foreclosed on. This created a glut of them on the market which drove down price.

To buy a comparable house I would need to spend probably 20% more and it would be 30-50 years older and would probably rent for only a little bit more.

It would need more maintenance because everything would be old. I would need to pay for things like roofs, siding, driveways, etc which are covered by my association fee now. Most of the places that have these kinds of houses that are cheap enough to rent are in much worse neighborhoods than I can get these townhouses in.

There are always trade-offs and decisions to be made. If I bought one of those houses instead of these townhouses I could probably cash flow a bit more up front but as soon as the big expenses come it would eat up any extra money and I believe I would have a harder time finding the quality of tenants that I do find.

I could have gone inner city and bought dirt cheap houses for 40K. I know some investors who did and claim to be making very good returns. Definitely better than mine. There are multiple reasons why I do not want to do that.

One other thing I want to mention with respect to my comment to Rick.

I run these numbers for all my properties with updated values at the start of the year. Not so much to get the ratios anymore but to get the cash flow and profit projections for the next year.

At the end of the year, the actual numbers that I bring to my accountant are almost an identical match to what my projections were at the beginning of the year. This has been true every year I have done it.

These ratios and numbers tell me exactly how my properties are going to perform over the next year or two with respect to cash in hand, and total gain in equity.

Apex,
Great info. Appreciate your effort and patience in explaining the ideas clearly.

Great article with detailed data one can use to calculate income figures on a future investment purchase.

Apex,

This is some great analysis and it all makes a lot of sense.

When I look at the market here (outside the USA) it seems like the Cap rates are only 3% or so, that seems quite unattractive, don't you think? Cap rates used to be in the 7-8% about 7 years ago when I purchased our residence.

-Mike

Rick and FMF -

While it is true that, all things being fixed, the returns would decrease over time as the mortgage was paid down, revenues aren't static. One great advantage of real estate which Apex didn't touch on in this article is that over time, property values will basically increase with inflation. So will rents. In 30 years, Apex may be getting $2,000 or more per month in rent. Also, and this gets deeper into time-value-of-money theory, at some point the original invested cash becomes irrelevant when you've been making money on it over time. At Apex's rate of return, he will get his cash back every 6-7 years on cash flow alone.

Beware of that community association fee. Expect it to rise accordingly with inflation and as the property ages. You will be assessed for community maintenance and repairs above and beyond the current monthly payment.

Attend some of the meetings so you'll have a handle and voice in what the association is considering. The cost of building repairs and upgrades in a condo can be quite shocking.

Apex - thanks for the great article (again!). My own experiences and numbers closely match your own. I have only ever really looked at cash-on-cash return and ROI, but I will look closer at the other two metrics.

I notice that your mortgage is at 5.25%. One great thing about the current interest rate environment is that you can refinance and make your numbers even better. A friend of mine has several properties purchased before the crash which are cash flow negative and have mortgages around 7%. He also has less than 20% equity despite having initially put 33% down. I showed him how, if he were to pay down his mortgages to get to 20% equity and then refinance to 4.25% (a rate we've been quoted for refinancing our own rentals), he could make as much as an 80% return on that "down payment" toward his equity and at the same time make his properties cash flow positive. You could refinance and probably save about $100 per month the same way (probably without first augmenting your equity).

Jonathan --

That is correct, but costs may rise as well (as Lurker carl points out). Houses eventually wear out and roofs need to be replaced, furnaces need replaced, paint needs updated, and so on -- much more than the basic maintenance we have in our annual budgets.

@Lurker Carl,

Very good point. I own multiple units in this association and am President of the board so I pretty much set the pace in this association.

The association fee will likely need to rise some over time (it was $198 when I took over and raised it to $210) but there will be no future assessments for maintenance. That is all part of the fee as we put money away for reserves. It is the law actually. It is true that many associations do not put enough away and need assessments to deal with it but I believe I have a handle on it and we will be prepared for future expenses.

One of the reasons why the fees are a little higher right now is that when I came into this association it was a mess. The units were nearly all investment owners all losing their properties (its a small association, 16 units and ever single one of them has now been foreclosed on now). The association was fairly new, fairly small and had no money. There was less than 9K in the bank when I came in and 1/3 of the units were not paying dues. We had little money and were going backwards. There was a risk of running out of money. 3 years later we have over 50K in the bank, every unit is paying dues and I have dramatically reduces expenses on things that were a waste of money in my opinion.

By the time we need to do any major replacements we will have more than a quarter million dollars in reserves.

One thing I want to note is that inflation is not unique to associations. Dues go up because things cost more. But if you own a house with a new roof, the cost to replace that roof in 25 years will be double what it costs to replace it today. Costs go up whether you are in an association or you own a house.

@Jonathan,

Very true on the refinance. However its not as easy once you get enough mortgages. I have about 6 mortgages right now so I have to fall under Fannie Mae's 5-10 rules. Those make things a lot harder. I can only find one broker who will even do them in my area and he lost 3 of the 4 institutions who would write the loans. If he loses the 4th I am going to have a lot harder time finding loans. He is so busy right now that he simply will not do refinances. So I pretty much have no option to refinance these loans at the current time. I certainly would if I could but sometimes you have to stick with good enough as much of a disappointment as that is.

@Mike,

I agree completely. 3% cap rate is horrible. I haven't given much thought to cap rates that low but I doubt I would find that an attractive environment to invest in.

Cap Rate isn't the real ROI if you are using leverage but if you can't get a cap rate above 5 it's hard to believe the other numbers will come out very well either. The numbers start to get good when cap rate gets up near 7 or so, like the numbers you mentioned that you used to be able to get.

A Cap rate of 3 sounds like a bubble to me. Something is not right with price to rent ratio when the cap rate is that low.

Apex, awesome post. I love how you break everything down and explain it all right below. I'm curious what you do with your cash flow from a property like this? Do you put profits towards another property?

@Veronica,

That is correct, I put it into more properties. I have lines of credit that I borrow from as well so I use extra cash to pay those down, then when I find another property I extract the cash from those lines to use as a down payment and get another mortgage for the difference.

Hey theres a good landlord tip : Get yourself elected president of the HOA for the properties you own. ;)

@Apex, thanks for clearing that up. Hmm, I need to learn more about this!

When you are talking about mortgage payments, you want to use "principal", not "principle".

I am a local Realtor in South East MI and these kind of returns are available right now because home prices are still low from the market dropping, but rents never really went down. We see many people taking advantage of these opportunities and it will certainly pay of years from now. 18% return on investment with a built in long term savings account (home equity) seems like an awesome long term investment. especially considering with depreciation you only have tax ramifications for a portion of that income. Some stocks may do better, but certainly not with any amount of certainty. For the long hall it is really tough to beat real estate when these kind of returns are available.

@Nicholas.

That is a good summary of why this works now. These returns are basically locked in on these properties for the long term. What is also true is that these returns will not always be available on new purchases. There will be a time again when it will be difficult to purchase quality homes and make any return at all in the rental market. That's when people have to go to much less desirable properties to get a return.

If anyone is interested in considering real estate the time is now. The housing market is already starting to turn up. I do not know how long this will last but it could be shorter than people think.

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