The Biggest Kept Secret – Hidden Returns of Rental Real Estate

Here is a discussion that will hopefully put to bed the annoying quarrel that people outside of real estate just don’t get. I’m going to show you the hidden ways you make your money on real estate rentals that blow REITs, Crowdfunding deals, and Real Estate Notes out of the water. There are potentially better investments (risk divided by reward) backed up by a hard asset, however, those deals are not obtainable by the average individual who does not have access to a rich and powerful network of people (not this bottom feeder one) and who does not have a net worth exceeding $1-million. These are the deals that happen behind closed doors in the country club crowd, but that’s not what we are here to talk about today. If you’re wondering, I too am Tiny Tim peering into that window of that exclusive party. The simple rental is something that is accessible to everyone and today we are talking about the math behind it. So put on your propeller hats, because we’re about to talk numbers.

As a rental investor you make your money four ways:

• Cash flow
• Appreciation
• Tax Benefits
• Principal Reduction/Debt Paydown

1) Cashflow

Cashflow is your income (rents), minus your expenses and mortgage. For example, if your tenant pays you $1,000 a month and if your monthly expenses including principal, interest, taxes, insurance, and maintenance/occupancy reserve are $800 a month, then the $200 difference is now income in your pocket. It is what you are left with on a monthly/yearly basis with little to no action on your part. The goal is to keep acquiring rentals that will increase your passive cashflow. It is this cashflow that is the money that you will live off of to be able to quit your day job. As in the board game ‘Cashflow,’ you win when your cashflow is greater than your expenses. When this happens you have “escaped the rat race” and able to spend your time doing things that are more meaningful to you.

I recognize that in the Real Estate investing community there are two camps A) Cashflow-focused and B) Appreciation-focused. Sort of like a political debate, you can’t tell the other is wrong for obvious reasons. SimplePassiveCashflow.com is on the A) Cashflow-focused bandwagon. We believe that acquiring assets that increase your cashflow is the way to go despite the fact that it is often a slower, more prudent road to take. Folks in the Appreciation-focused group feel that buying homes in the Midwest is silly because those “fly over States” never appreciate, and they fail to see the hidden benefits of real estate, as stated in this article. I buy, knowing that the home I purchase for 80k today will sell for 85k, 20 years from now. I underwrite my deals to look at the bigger picture knowing that it is the cashflow that will eventually replace my day job income. I admit that this will widely depend on what you use as the assumed average appreciation for the purchases in markets with more rapid appreciation, but appreciation is not constant- it is cyclical, and I prefer to see a steady rise. By purchasing in cashflow markets, the highs aren’t as high, but corrections aren’t as painful.

This is a little off topic but I run a passive investor Meet-Up in Seattle, and there is always an old-school investor who is investing for appreciation and was one of the unlucky folks. Basically, what happened is that they bought during the wrong time in hopes that the market would go up 5-10% every year, but instead, they are underwater, and to add insult to injury, they bought it with negative cashflow and are still losing money every month. What is most important is the aftermath, and now that investor/gambler is in the doldrums for nearly a decade unable to do anything in terms of building his/her portfolio. Kind of like that idiot buddy of yours who went all-in early in a friendly game of poker, and now he is sitting on the couch by himself like a jackass while you and your other friends are still playing for a couple hours. Here is another analogy… appreciation is like a 3-point shot in basketball, where a team can choose to jack up 3-point shots all game. There is a saying “live by the 3, die by the 3.” Now, I know the Golden State Warriors are debunking my analogy with all their 3-pointers, but if I were the coach I prefer to just pound it in the low-post for the higher percentage shots – maybe that’s why I like the low appreciation-high cashflow rentals because they prefer the high percentage shots – the slam-dunks.

Example:

$30K initial investment creates $3,600 per year profit (cashflow)

3,600/30,000=12% is the Cash on Cash Return
2) Appreciation

This is the famous topic of dinner/cocktail parties where people brag that they bought their home for 200k and now it’s worth 400k and how they had incredible foresight. Well congratulations, appreciation “floats all boats – even ones with holes.” Despite how cool it sounds, appreciation is a hidden benefit that you only realize when you sell your investment property for greater than what you bought it for – it’s a paper gain. Even though you can’t live off appreciation like cashflow (well you can via HELOC or refinance but that’s a topic for another day), let’s attempt to quantify it. So if you bought a home for 100k and it went up by 5% which is a pretty good year, your property would be worth 105K… but wait…your initial investment was 30k so now you have 35K. Here is the math.

Example:

$30K initial investment creates $5,000 this year in equity gain

5,000/30,000=16%, is the appreciation return (3x on a 5% market gain)

I’m not a fan of including this in my underwriting because I believe it is gambling but just wanted to show you the math behind it so you can see how your leverage is at work with Government subsidized loans. Another reason is that I like to sleep at night, so I don’t care about appreciation. Plus I don’t have a crystal ball. It’s interesting to note that when the market goes down, more people can’t afford homeownership and turn to renting, which is good for the landlords. Thus, while an economic downtown is generally bad for those banking on appreciation, my monthly cashflow is more resistant to economic changes.

3) Tax Benefits

Your rental is a business, and if your expenses are tracking ~50% of your income, then you will be running at a near zero profit business on paper and not have any taxable income. If you are super-sneaky, you can also pass expenses through this business of yours, but work with your CPA first and don’t get greedy. Taking illegal shortcuts will definitely cost you in the long run.

But wait… the cool thing about real estate is that you can take a depreciation deduction off your taxable income. This amount is dictated by taking 1/27th the building value of your property for the first 27 years of ownership. With the expenses negating your income this depreciation incentive is taking that amount off your W-2 day job income. (Side note – unlike stocks/other assets when there is a capital gain you pay taxes on the gain you can avoid capital gains tax when you sell by using a 1031 tax exchange.)

Example:

100K home has a typical building value of ~$70k

$70k/27=$2,600 per year that you are able to write-off

$2,600 at the 25% tax rate is savings of $650 per year

Going back to the original investment: 650/30,000=2% is the tax benefits. Not bad but I’ll take it.

4) Principal Reduction

When you rent out your home, your tenants are paying down your mortgage a little bit each month with their hard earned money – not you. You can download a great mortgage/amortization spreadsheet by signing up with your email on the sidebar menu. In the beginning of a mortgage, most of the payment is going toward the interest payment side as opposed to the principal pay down/equity for you. Just know that you don’t realize any of these gains until you sell/refinance the property but it’s there.

100K home (with 25% downpayment) has a typical PITI payment of around $550/month. Of that 550 only ~$150/month or ~$1800/year is going to principal paydown as equity gain.

Example:

1,800/30,000=6% is the Principal Reduction benefits

Hey there congratulations on sticking with the article. Take a break and the summary of the numbers are below:

The Scorecard

• Cash flow=12%
• Appreciation=16%
• Tax Benefits=2%
• Principal Reduction=6%

Total=36%

In this conservative example, (although there is no guarantee in anything) the totally is 36% return. Pretty dang good with you compare with that mutual funds. The problem is the average person overlooks these hidden ways you make money.

Love Hate Relationship with Appreciation

When I purchase investments I define my goal as cashflow over appreciation. Like many things in life, you can’t have it all, such as both strong appreciation and strong cashflow as described in the Cashflow Quadrants. I invest in the boring “cashflow markets” because I define my endgame as needing passive cashflow that I can live off of. Appreciation is something I cannot live off of since it does not appear in my bank account each month. I see appreciation as the icing on the cake or the dessert with the meal. Therefore, I remove the appreciation from my calculation/underwriting and plan for those projections. For example, if I buy a $80K property in Atlanta today, I do my spreadsheet calculations knowing that I will sell the property for ~$85K 10-20 years from now.

I recognize appreciation has the potential to be a very large part of this return in terms of a colossal windfall in a good market (10% equals 40% gain with typical leverage) however there is also the potential for large downswings. Frankly, I try to simplify my life and therefore I am not cool with the volatility and is another reason I don’t use stocks/mutual funds. Every rental will have a different blend of these four ways to make money. In this example above, I plugged in the typical low appreciation potential of “cashflow markets” that one might call “fly-over towns” such as Birmingham, Memphis, Indianapolis, Atlanta, to name a few. These “cashflow markets” typically have boring low single digit appreciation rates (San Francisco might appreciate 15% whereas Birmingham might appreciate 2% in the same year) however in a recession they don’t have the double-digit dips that a California/Seattle market will likely see. I tell a lot of investors who purchase homes with negative cashflow such as a $500k rental in Seattle that rents for $3,000 per month (See Rent-to-Value Ratio) that they need to be conscious of what the numbers are telling them. If they can look me in the face and say they are investing for appreciation then I am cool with that – that is their goal. However, most people in this situation (Mom & Pops who were taught to just buy a property dispite if it made fiscal sense) are clueless that they are losing money to the tune of a few hundred dollars each month in cashflow. If you every played Paigow Poker, investing for appreciation is like the “fortune bet” where you keep paying into the side bet in hopes of hitting it big one. You might hit it big one day, but then you need the wisdom to cash in at the cashier’s cage.

The Scorecard (Minus Appreciation)

• Cash flow=12%
• Appreciation=16%
• Tax Benefits=2%
• Principal Reduction=6%

Total=20%, not bad and still greater than the stock market.

For those stock-centric folks look at it this way. Appreciation in your home is similar to the gain in the price of a stock like Apple. The price of the stock goes up and down, however, the volatility is much less with rentals. There are some stocks like AT&T that produce dividends and those are similar to the cashflow from a rental. However, I don’t see many dividend stocks producing more than 4% compare with the double-digit cashflow returns from rentals.

Other hidden ways you make money that I do not consider: Equity Capture

This is when you buy a house for less than the market value. Many people say “you make your money when you buy” and this is what they are talking able. Personally, I pretty much buy at market value. I don’t have the time to do any work to find any deals which involve the arduous tasks of doing the direct marketing, tracking down leads, fix properties or any of these active real estate investor past-times.

I’m pretty lazy and lazy people don’t deserve much… well unless you’re smart about it, but even then. Another example of this is if you bought a house for $50K, put $30K into rehab (all in for $80K) and now the property is worth 100K on the open market (disregarding transaction costs) – you just created $20K of equity capture. The following way is a great way to acquire assets, but it requires money, time, and effort (that might have a higher and best use at your day job).

Other hidden ways you make money that I do not consider: Inflation Hedging

When your parents bought a home back in 1985, they spent about $30K on the property. Their mortgage payments were ~$100-$125 dollars per month and at that time that made up a noticeable portion of their family budget. Now fast forward to today and they are still paying the same payment (taxes and insurance have gone up). This illustrates how by having a mortgage you are locking in and hedging yourself from the inflations. Here are other reasons supporting inflation is going to be greater in the future:

• The past 30 years has been a semi-calm era that yielded 3% annual inflation. However don’t believe the BS. Call me a conspiracy theorist but I would argue that it’s much higher than 3% since it is the government that is cooking the data. Just look at the ice cream container, the price has stayed in line with inflation, but the size just keeps getting smaller and smaller. There isn’t even real sugar in the thing.
• The knee jerk reaction from the US Government is to bailout the big banks from falling by keeping interest rates synthetically low for almost a decade. We will have to pay this back at some point, just look at the Federal Debt Tracker, Government shutdowns, and our Country’s devaluation from the AAA grade. At some point, we will have to pay it back via two options. The one unpopular option is to raise taxes/decrease Government programs, however, that is the quickest way to piss people off so that is not going to happen to the extent it should. Instead, the Government will just keep printing more money which will devalue the amount of money they owe. This will lead to greater inflation however the average American will not see the connection and blame it one those who are in office. What an ingenious way or an insidious way to devalue your debt without taking the blame.
• We are already seeing some European countries and Japan (cause every new comes from those crazy Japanese) test out negative interest rates. As absurd as it sounds this is where you have to pay money to the bank to allow it to remain there.

I’m not saying that it’s going to be a totally new world order but the best day to buy (and lock up 30-year mortgages) was yesterday and the 2nd best is today. Don’t use the excuse “Oh, I’m waiting for the next crash or evaluations are too high”. Instead, buy on fundamentals with healthy spreads in cashflow so when that next correction comes you are above water in terms of cashflow.

The Skinny

Rental real estate is the most time-tested wealth-building tool available to the average person. If you weren’t paying attention earlier, here is an acronym for you to explain to your naysayers who think you are crazy:

IDEAL

Income

Depreciation

Equity

Appreciation

Leverage

Q: I have $300k. Why not just buy three $100K properties that rent for 1K/month, rather than ten mortgaged properties? If you suspect there will be little or no appreciation, why not pay in cash and eliminate all risk?

I am not a lawyer but, consider another view of risk. The risk we don’t think about is having equity in your property. If there is a lawsuit, you can bet you are a bigger target if you have a bunch of equity in the property. If you have prudently leveraged your investment, it’s going to be a smaller target to go after.

A lot of experienced investors and non-experienced investors use large sums of cash to obtain properties at great discounts (70-80 cents on the dollar) via direct sales of pocket listings or auctions. Paying cash commands respect and is seen as a more reliable deal which is the reason for the discount on the property. The following will analyze the numbers behind this strategy and compare it to a typical 20% down payment conventional deal.

Scenario A: All Cash
Market Value: $100,000
Purchase Price = Money in the Deal: $75,000
Annual Cash Flow: $12,000 (assuming 1% rule)
Cash on Cash Return: 12k/75k = 16%

Scenario B: Typical 20% conventional deal
Market Value = Purchase Price: $100,000
Money in the Deal (20%): $20,000 + $3000 for closing costs above and beyond Scenario A
Annual Cash Flow: 12 months x ($1,000-540(PITI)) = $5,520 (assuming 1% rule)
Cash on Cash Return: 5520/23,000 =24%

Under these circumstances, purchasing all in cash would yield 8% less in returns on your principal investment. While the cash-on-cash return will vary between properties (and is only one part of the total sum of ways you are making money as discussed in this article), using leverage will allow your money to go further. However, do the math for yourself.

SPC Git Er’ Done Action Plan:

• Look for “Lazy” money making a return less than 10% and consider
• Challenge your belief that stocks or mutual funds should have a place in your portfolio.

“Diversification is for idiots”

–a Rich Bad-Ass