@Ali Boone
@JT Spangler
@Duncan Taylor
First Thank you for the very interesting discussion on how real estate investors should approach risk, and what he/she is comfortable with.
I think what both of you are saying is that likelihood (or probability) is less when you are not leveraged (fewer units) , The impact could be more severe than if you leveraged and owned more units
Let me quantify
Basis From example above
$300K start with
$50 K houses / Rent $750
Expenses (%50) $375 ( you still have taxes and insurance regardless if you carry a mortgage or not)
Appreciation 5%
Option 1
Buy 6 $50K houses free and clear
Starting equity = (300K value – 0 Loan Balance) = 300K
Income = $750
Expenses (%50) $375
Cash Flow $375
Times 6 units = 2250 Month (same as Mr Duncan Demo)
Option 2
Buy 12 $50K houses ($25K Down, $25K Financed)
Starting equity = (600K value – 300K Loan Balance) = 300K
Income = $750
Expenses (%50) $375
P&I (25K at %5 for 30 years yields monthly payment of $134
Cash Flow $240
Times 12 units =$ 2880 Month
Risk assessment / Management
While the probability of getting a bad tenant is more with the greater # of units, The IMPACT would be less:
Risk Analysis
Hazard : getting a bad tenant that late/skips on rent
Effect: you lose one months rent ($750)
Probability of Incidence (PofI) = in our example 1 in 20 (5%)
Option 1
PofI = 6 units *(.05) = 30% chance
Impact + (-$750 cash flow ) -> Net cash goes from $2250 to (2250-750) $1500 a (%33) decrease
Option 2
PofI - 12 units * .05 = %60 chance you get stuck
Impact = ((-$750) cash flow -> net cash goes from $2880 to (2880 – 750) 2130 = 26% decrease
So while the chance Is greater with multiple units , the impact is lessoned due to the other income streams.
We can take the same line of reasoning when Analyzing other Risk Hazards such as loss of income; loss of property ; (house loses entire value) ;
In addition , I think we need to look at other non cash returns when considering leveraging versus non leveraging, as some of Leveraging benefits don’t show up on the cash flow line
Total return
Calculate total return for scenario sake – assume 25% tax bracket and 5% appreciation
Option 1
Cash 2250 Month * 12 months 27K a year
27K / 300 K = 9% ConC return (as stated)
Other returns
Equity build up = $0 (already %100)
Tax savings (assume 40 K tax basis , 27.5 year amortization )
$1450 per year DEPR allowance * 6 houses = $8700
$8700 DA * .25 (tax rate) = $2175
Appreciation
Appreciation 5% = 50,000* .05 = $2500 year appreciation
2500 * 6 (houses) = $ 15000
Total return = Cash + equity + Taxsavings + Appr
= 27000+0+2175+15000 = $44175
4175/300000 = 14.71 total return
Ending Equity => Value – Liability = ($300K *1.05) – (0) = $315K
Option 2
Cash 2880 Month * 12 months = $ 34,560 a year
34.45K / 300 K = 11.52% CoC return (as stated)
Other returns
Equity build up
Using financing model above (25K financed at 5% over 30 years ) – yields $360 equity build up in year 1
$360*12 houses = $4320 Equity build up
Tax savings (assume 40 K tax basis , 27.5 year amortization )
$1450 per year DEPR allowance * 12 houses = $17400
$17400 DA * .25 (tax rate) = $4350
Appreciation
Appreciation 5% = 50,000* .05 = $2500 year appreciation
2500 * 12 (houses) = $ 30000
Total return = Cash + equity+Taxsavings+ Appr
= 34,560 + 4320 + 4350 + 30000 = $73,320
73,320/300000 = 24.41 total return
Therefore you get more sizeable return on your money for assuming the probability of more risk, even if the impact is lessened
