Advice on buying rentals, flips or loaning out cash?

[Alec Sithong]

Hello BP'ers,

I need some advice on which direction to go: with a starting capital of $125K, which is the most affective way to get cash return in a year or two? My goal (like everyone else) is to aspire to live off of passive income by obtaining multiple rental properties. Is the best method for quick return on $125K cash within a year or two: 1. Flips 2. Flips & Rentals or 3. Be a hard lender?

[Jered Sturm]

@Alec Sithong When it comes to real estate investment the two most powerful things are debt (leverage) and taxes. Typically you receive neither of those benefits when doing hard money lending that you mentioned. Flips are sort of a middle ground between the two. Flips are a ton of work, and far from a passive investment like you mentioned you wanted. 

I have wrote this out for another example so I used $100k rather than $125k but the example should still illustrate the principles.

Here is an example of two investment channels you mentioned:

Hardmoney lending:

$100k lent out for 1 year at 12% interest w/ 2 points will give you a gain of $14k or a pre tax COC of 14%. Lets assume you are in a 35% tax bracket. You will cut a check to the IRS for $4,900, leaving you with $9,100 or a after tax cash on cash of 9.1%. Also keep in mind HML your money turns over quickly you have to be active to be sure you have another qualified borrow lined up needing your money at your terms or else your money just sits dormant between loans, and dormant money is decreasing money.

Apartment building investment:

$100k down payment on a $500k building. At an 8% capitalization rate (very achievable) you are left with $40k net operating income. lets assume when you borrowed the $400k from the bank they lent it to you at 4% interest over a 25 year term. This means your year one mortgage payment is $25,332 ($15,827 interest, $9,505 Principle) leaving you with $14,668 in cash flow or a pre tax cash on cash return of 14.6%. This beats your total pre tax return of 9.1% from the HML above BUT we haven't even started on all the other benefits of investing in real estate.

So you cash flowed $14,668 do you pay tax on $14,668?? NO! Another beauty of real estate and leverage is the depreciation tax benefit. Even though you only put 20% of the $500k in to the property you get ALL of the depreciation. Apartment buildings/houses are depreciated over 27.5 years, which means you get to depreciate the building value. The buildings value does not equal the property value because the building sits on land and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value to allocate to land value is 20%, or in this example it would be $100k. This leaves you with 400k of building value to be depreciated $400k/27.5=$14,545. What does this mean? It means you barely pay any tax on that $14,668 cash flow you made on the building. You actually only have a taxable gain of $9,628 ($14,668 + $9,505 - $14,545) we add back the principle amount of your mortgage payment because it is not deductible and subtract out the deprecation we listed above. Again assuming a 35% tax bracket the gain of $9,628 would result in cutting a check for $3,370 to the IRS. This means your after tax return is 11.3%. A 2.2% increase on after tax return when compared to hard money lending

That's all great and will make you a lot of money, but HML has no tenants, no phone calls, no toilets. That piece of mind in its self is worth not receiving the additional 2.2% return owning real estate provides right? I don't think so because there is one more major piece to this puzzle.

Another huge difference between HML and owning investment real estate is the power of debt and with debt comes amortization. Wealth is built in the amortization of the debt you put on the property. Back to our example the $400k in debt you put on the building will have an army of tenants paying down your mortgage month after month. In our example after 10 years you will only owe $285K on the building IF the property never appreciated one cent and it was still worth $500k in 10 years you would have $215K in equity. You could then sell it or refinance it (again tax free).

Now lets wrap the amortization into our example. Using the loan terms I mentioned the first years of the loan will result in a $9,505 reduction in principle or if the value stays the same that would be seen as a $9,505 increase in equity. If we add that $9,505 to the cash flow and tax benefits we are left with an all inclusive after tax return of 20.8%.

This is just the basics. You can accelerate depreciation benefits through cost segregation, Structure loans for quicker amortization depending on your goals, force appreciation through several types of improvements, and many other tricks.

Everyone has their own specific investment tastes and beliefs. I post this here to hopefully help you make your choice. Good luck on your new venture!