Is This Irresponsible or Sophisticated?

Question

Trying to determine if this is reckless or sophisticated investing....The idea is that annual percentage increases and the possibility of rates lowering will allow for positive cashflow.

-A property with a 30 year mortgage would be neutral cash flowing, but in a solid location and with strong demand.  Current annual income is $101k

-Annual rent increases of 3% are realistic making annual income after 10 years $136k

-If interest rates lower a refinance would lower annual mortgage expense

-an added bonus over time would be appreciation (which will likely not happen within the next few years)

Thank you for any input!

Brett Deas · Answer

The only thing I would say is never base your investment based on future rent increases, no matter how 'realistic' they may be. Many people bought relying on rent increases, and now are in big trouble when average rent actually has gone down in many areas.

V.G Jason · Answer

If an asset is priced intrinsic in times when the cost of capital is higher relative to the last 15 years that should be the most suspicious. If the fundamental basis of investing is strictly cash flow, you'll want to make sure your net income per month is actually double your mortgage. Anything less is truly not cash-flow.

You want to not buy based off just intrinsic or cash-flow centric but the qualities of the property and the area. How big is the land, cost to rebuild, insurance issues, economy in the city, accessibility, population. If all those are growing and in the right direction, you're actually hoping over time the property becomes even less intrinsic to buy so the earlier you get it(assuming price moves up over time) the better.

The assumption to disengage from possible rental increases is as asinine as thinking insurance and taxes don't increase. Will it go up linearly? No. Will it go up in a straight line? No. Will it be up & down yes. That's why you invest, don't trade, in physical assets. Give it at least 8 years, closer to 12-15. IF you don't have the balls or finances to weather that kind of time frame, go buy some equities or govt debt.

V.G Jason · Answer

Fundamentally, what the asset is worth independent of market value. In this case,  for the CF-guy here on BP, I mean in the in-the-money-- cash flow positive.

William Coet · Answer

Thank you for the reply.  I appreciate your insight.

I'm trying to understand the term "intrinsic" and how you are using the term in this post.  I looked up the definition of intrinsic value and found this and wondering if there are any specific differences in the real estate category as you are using it:

"In finance, the intrinsic value of an asset or security is its value as calculated with regard to an inherent, objective measure.A distinction, is re the asset's price, which is determined relative to other similar assets."Thank you

Jonathan Greene · Answer

In theory, this is not dumb at all. I call it a double windfall. If you buy in with a high rate, wait two years, and your property appreciates and rates come down, you get a double windfall when you refi because the payment goes way down and you have equity to pull.

BUT, that is a big if in today's market. I think speculating on lower rates is not great. I do think within two years they will be better, but people waiting on 3 to 4 percent are going to be waiting a long, long time based on the data.

Buy assets. Some assets start as break-even, but you see the scale. Think of the lowering of rates, if they happen in the timeframe you want, as icing, not the cake.

Alecia Loveless · Answer

@William Coet I just passed on a property that the price negotiation on got to where it was almost a break even scenario. This property was essentially turn key and needed less than $5000 in work to get it able to make closing. Later it needed a new furnace but that could be done after it was rented.

I’m looking for cash flow and am not afraid of value-add properties requiring work. In light of my goal for cash flow I turned down the above property.

I think to determine whether you want to do this deal or not you need to look at your long term real estate investment goals and see if/where this type of a deal fits in.

For me in my case simply HAVING another property that was being paid for by my renters was not the end result I wanted so now I’m looking for other properties.

Don’t get caught up with just wanting to buy a property and hoping it will work out in the future based on projections. Look at your end goal and see if that strategy fits. If it does then buy it but if not walk away there will be other properties.

Ryan Porter · Answer

How much is the buy-in? If the downpayment + closing cost is free, and you are doing a triple net lease to keep any repairs on the tenant in the next ten years, it may be worth the trouble. The 30-year amortization I am not crazy about either. If you could make it break even on a 15-year note, that would be an entirely different story. I wouldn't want to take a break-even property with any risk at all. Unless it's an Airbnb that I could stay in a few times a year, haha!

Kevin Sobilo · Answer

@William Coet, I would call it neither irresponsible nor sophisticated.

I think the general thinking is good but here are a few things to think about.

1. I would define cash-flow neutral as not only accounting for my hard expenses but ALSO things such as maintenance, capital expenses, and vacancy. It wasn't clear if you were accounting for those in your scenario.

2. When estimating, I would work up multiple sets of numbers to see how it might work out if things don't go to plan.

3. This is market dependent, but I would consider 2% annual rent increases typical, 3% optimistic and 1% conservative long term in my market.

4. I would also account for a % increase in expenses per year.

5. For a property with $101k income, it might be worthwhile upon purchase to do a cost segregation study so that you can front load the depreciation. The money made isn't what counts, it's what you get to keep! So, reducing the income tax is always a plus.

Is This Irresponsible or Sophisticated?

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