There was that time I out-bid a more experienced cash buyer.
And bought the property below the list price.
Buy Your Place in Line
I listen to and read a lot about real estate investing.
It's 95% men.
Their stories are about the same: they work all day and their wife (or someone) is looking after their kids and home life.
While most list their family and children as their hobby, not once have I heard these men talk about the challenges of managing their family logistics with building their business.
It may seem logical that the greater the leverage, the greater the cash on cash (COC) return. And you would be right. But it is not linear. A leverage increases, COC increases at at a steepening rate.
If you're confused by these measures and how to use them, don't be!
Like all metrics, they serve their own purpose, but it's important to know what that is.
The first step is by far the hardest.
Like many investors, we started with a book on the basics, and went shopping. Our first purchase provided zero financial value over the six years we owned it, but it was an invaluable teacher that guided our subsequent purchases that have doubled in market value over four years while providing us with a 10% annual return on our cash investment.
Three Simple Rules
I have heard and read plenty of opinions and convincing arguments as to why real estate investments beat stock market investments as a retirement strategy, but I needed to see the hard data. And here it is.
The Bottom Line
It's not for everyone. Saving and investing in an index fund takes a bit of planning and personal fiscal discipline, but little else. Saving, buying, and managing investment real estate, and to do it well, is running a small business. Basically, both will get you there, but with differing levels of certainty and work. Pick your poison!
IRA and 401k Analysis
First I found the average annual return for the US stock market. Using moneychimp.com's calculator, I found that the lifetime compounded annual growth rate (or CAGR) of the S&P500 is 6.7%.
Ok, now let's apply this to IRAs and 401ks. For this example, assume the best case scenario of a person using both an IRA and 401k, making maximum annual contributions of $17,500 and $5,500 (a total of $23,00 annually), starting at age 25 in 2013. This person would need to be making $90k a year to be able to afford this 25% savings allocation, but I'll assume the savings rate regardless of income. Here is the projected result:
These results already account for inflation, and we can assume tax rates will remain largely the same at retirement at this income bracket. Looks like our investor is well positioned to retire at 65 on a comfortable $45,000 - $82,000 annually. Which seems OK, unless you require long-term care at $150k per year...or the stock market loses 30% of its value when you go to retire....or inflation really runs rampant sometime between now and then...or health care costs keep rocketing upward. All very real possibilities. What if one or more happens? Then what?
And, of course, the market doesn't move along a nice steady rate of return. It moves in cycles of high and low return. Unfortunately, no one can control this. If our investor starts investing when the market is at a relative high (sort of like it is now), chances are it will return to a low at the least convenient time - at retirement. Or maybe not. It's just luck.
Investment Real Estate Analysis
Following the same logic we used above, let's start with the CAGR for real estate in the US. From 1890 - 2008, US homes appreciated at about 3.5% annually***. That doesn't sound so good when the S&P500 has returned nearly double that over the same period. If we assume average inflation of 3%, that means that in real dollars, real estate doesn't actually appreciate over the long-term. Sometime it does appreciate, and sometimes it loses value - I think we've all seen very good examples of both scenarios over the recent past. So we still have volatility and up and down cycles - like the stock market - and no real growth. So why would anyone invest in real estate?
To illustrate, let's assume our investor buys a $160,000 home with 20% down, rents it for $1,400 per month, and sells it after 30 years. Our investor experiences 8% vacancy and 15% of rent maintenance costs annually. Here is a screen shot of my personal property analysis.
Notice in the yellow box above, my real rate of return is 15%.
In the end, we get a CAGR of 15%, with a net present value of $162,00 (when I change my discount rate to 4.5%) on our $32,000 investment. As a bonus, I am accumulating $3,000 annually as profit. That's like a 10% dividend. And, if the property isn't sold, but retained in 30 years after the mortgage is paid off (and future dollars are the same as today's dollars), we are getting about $855, net per month - indefinitely. To get to the equivalent retirement income we used above of about $4,000 monthly, we need to compound our $855 by 4.5 homes. If we own 5 homes outright, our annual income is $51,300, and we aren't depleting our principle, unlike our stock investments. Should we need additional income in retirement, we can liquidate all or part of our $800,000 portfolio ($160,000 * 5 homes).
So, am I going to quit the stock market? No. But, I am diversifying.
Water is always flowing. And so is money. Even if you have cash sitting in a box, your money is moving.
How can this be?
Think of your business (which is your real estate) and all the ways that money moves in and out, much like a body of water. The best type of investments are those that are like a reservoir with a steady water supply flowing in and filling up the reservoir. The water comes in, is collected, and released slowly for expenses, or perhaps all at once upon sale of the property. But even in this system there is a leak. Just as few things are water tight, so even the best property is not perfectly cash flow efficient. There is inflation, changes in property and income taxes, loss of tenants, and so on that create holes in your cash reservoir. Same for that cash stashed in a box-inflation is like a slow leak on the value of your non-working cash.
This is why understanding and managing cash flow is of the utmost importance in personal and business finance. Otherwise, your cash flow can quickly change direction and rather than watching your cash reservoir fill, you are suddenly watching it draw down and dry up. But even worse, you are likely going to have to find other sources to keep the cash flowing to cover your obligations, like debt payments.
While this concept is very simple, many investors (including myself) somehow managed to dismiss this basic principle of how money is made, and instead put complete faith in the rising tide of appreciation to more than cover our negative cash flows because real estate never goes down in value, right? Today, we all know that the huge IF, as in "if real estate appreciates, we'll make money" was the silent killer. (I'll be writing more about how IF will kill your business in another post). Couple this with another silent killer IF, as in "if rental rates increase at least 5% annually", but they don't - and in fact rental rates sink, and you have yourself a serious cash flow problem.
I learned this lesson personally, but fortunately not too painfully. After spending what seemed like a lot of time looking at property (a huge time waster and backwards way to find investment property - yet another future topic of how I find, analyze, and purchase property), which only makes sense if you're looking for a personal residence, we purchased a studio condo in downtown Portland. At first it was good. Our rents were increasing. Our tenants paid on time and left the place clean. But we still weren't making money. Our rental rate rose from $850 a month to $950 a month over two years. We had some appreciation. Then 2008 came. The condo market got really soft (leaving us with no equity), the rental market took a dip (forcing us to bring rent down to $775), and HOA and property taxes continued to climb. Ugh. After taxes, we weren't losing much but there was no way out without walking away from our 20% down. Selling would have left us with a zero net gain. I mean, zero. No cash to take home. This is an especially bitter pill to swallow when unclogging drains or performing other unsavory repairs, all the while remembering that I'm not making any money on this deal.
Now, I always keep cash flow in the front of my mind because I like getting checks a lot more than writing them.
Hi! I'm Christine Kwasny.
Why Fall Line?
Fall Line sums up what we live for - skiing and mountain biking. The goal is to maximize our ability to follow our bliss through work that is personally and financially rewarding. So far, so good!