Expectation - Reality = Disappointment!

Expectation minus reality equals disappointment.This mathematical phrase best describes what happens when people try something new and expect one thing but the actual results are less than impressive.When someone decides to get started in real estate for the first time, they may have misconceptions about the financial rewards at the end of a project.The resulting disappointment causes a lot of people to give up when they have just started on the path to success.Let me explain.

Buy and hold real estate generally does not produce super impressive results when you first get started.If you do all the work necessary to do one house from the purchase and renovation to finding a qualified tenant as an example, and at the end you only clear between $200 to $250 per month in cash flow you are not exactly set for life financially speaking.

This may be a major reason why so many investors get hooked on flipping houses.The profits are much larger and you get a higher hit of adrenaline when you see the net check at closing.What folks fail to realize, in both sets of examples, you must repeat the process over and over again regardless if you decide to buy and hold or flip.

Tell me what business exists where you do something once and retire?No, it is about repetition.McDonald’s sells billions and billions of hamburgers.Great businesses are created with systems that generate predictable, consistent profits that grow over time.

One of the partnerships I am involved with has been in business for a little over two years and we just filed our partnership return.Gross rents collected were $70,000 for five houses and the net taxable income after interest and depreciation was $1,597.After I sent a copy of the tax return to one of the partners, they responded with the sarcastic comment “we are really raking it in.”

While I agree this is not an impressive figure for the annual net taxable profit, what we all should keep in mind is this is a long-term game.One year is not enough time to judge whether financial results are good or bad when you begin investing in real estate.The idea is to buy and hold for the long term and the longer you hold on to it, the more cash flow and appreciation you get.

Ultimately the best cash flow comes when a property no longer has to make any debt payments because the bank will be receiving the lion’s share of the cash flow for the first several years.Each year, if the market is strong and growing, the buy and hold investor has the opportunity to increase rents as the leases mature on an annual basis.If someone moves out, you also have the bigger opportunity to mark up the rent much higher than the last tenant if the market supports this higher jump in rents.

At the same time rents are gradually moving up years on down the road, the principal balance is being paid down on the original loans used to purchase and renovate the property.This is the monthly reduction in the principal that you do not feel but it is a part of the return on the investment, nonetheless.Generally, I like to think of the depreciation being more or less the reduction in the principal balance on the loan so I can get a feel for the dollar amount this event is putting in my pocket, although it is not tangible dollars until after you sell the property.In the case of this partnership, the total depreciation taken on the tax return was $15,315.

Then there is the other unseen profit engine that is even harder to see:property appreciation.Once a property is purchased and renovated, it is time to get a bank loan.Banks require appraisals on each loan they make and this figure is given a lot of weight even though it does not mean someone is willing to buy your property for that amount of money.

Your local government will also “appraise” your house for property tax purposes every few years.Banks typically look at the “tax card value” of a property to get a quick idea of the current value as they have found these numbers to be fairly conservative in times past.

Last week, I had six letters from the county property assessor telling me their opinion of the new value for my partnership properties.Are you ready for some real figures?The six properties before had a combined tax value of $635,100.Four years later, those same six properties had a combined tax value of $1,151,500 which is an increase of $516,400 or 81%!

Since I have more than six properties, this number will be dramatically higher as more letters come in the mail in the coming days.The point is, this is a tremendous amount of “unaccounted-for value” that most people never see because they don’t hold on long enough to ever see it.

Before anyone thinks I get too excited about these values, the truth of the matter is our partners don’t feel half a million dollars richer the day we got these letters.First off, it is not like someone is offering to buy these properties from us at these prices.Secondly, we are buy and hold investors so this value is meaningless to us as the cash flow generated from the properties had not changed as a result of these new values…..yet!

If someone flips houses, the profits are greater on the front end than people will see if they buy and hold.However, they are killing the golden goose each time they sell the property and then they must go out and find another one to replicate the cash they just received and spent on living expenses over time.Unfortunately, success also attracts competition and the higher the number of people jumping in the market to do the exact same thing will cause a drive up in the price of houses and compress the margins (profit) for the houses that are renovated and sold.

Eventually, the supply and demand of a local market can be flipped upside down so that houses don’t sell for the profit they once brought or the market is saturated or a recession can kill this whole process. Then folks are left holding the bag of unsold inventory which costs money to maintain if nobody wants to buy them for enough of a price to make a decent profit.

Meanwhile, the buy and hold people are sitting back collecting their meager cash flow after expenses and waiting for the day these properties are paid off.Then they are rewarded for their patience with killer cash flow and a highly-appreciated property they can sell for a large sum should they want to convert this equity to cash.Buy and hold makes a lot of sense but it might take twenty years to taste the fruit of your labor.For some people, twenty years is too long.For others, it is the price you pay to have an asset that will serve as your personal ATM that can be passed down from your children and your grandchildren!