Introduction
The following is a discussion of two long term rental real estate investing models using different perspectives and tactics. The main purpose of this paper is to allow readers to compare and contrast the two different models and make decisions about which model is superior, and/or which model best suits their investing style. The links at the top of the page allow you to navigate from the written description (Explanation), the variable details (Details), and the supporting lifetime breakdown of investing activity for each of the subjects (Subject 1, Subject 2).

What is a model? In terms of this analysis a model is a set of circumstances using specific criteria, setting as many factors to equal as possible. Simply put, I have created a lifetime breakdown annually for each investors type. They all buy investments using the same logic and timing, they all make the same amount of wage income, they are all taxed the same way. The only difference between the 'Subjects' (or differing models) is the way they finance their long-term real esate investment purchases. As you look at the tabs above for the different Subjects/Models you will see the end result of using different approaches to aquire rental property, and how the differing approaches significantly affect the results of a lifetime of investing. How much money do they make, what is their net worth, how many properties do they aquire, how much tax do they pay, and how much risk is each investor exposed to are all effected by the decision of HOW to finance their invesments.

Below is an indepth discussion of my methods, how I arrived at calculations, general information about real estate investments, beginner information on the benefits and risks of real estate investments, tax consequences, a comparison of the end results of the different investing models, and a discussion on how to decide which one is best for you. If you have questions or comments about the model or are interested in exploring long term investments based on your personal circumstances please contact Richard Bowen, CPA at Richard@BowenAccounting.com or 661-342-0087.

About the Author
My name is Richard Bowen, CPA. I am the owner of a small accounting firm and have been doing accounting and tax since 1999. For my whole story you can read the 'Who is' section of my website. I have had many years of experience working with property managment firms, and giving advice to my clients about long-term investments of all types. I have had the opportunity to see real world investing models put into place and see which ones succeed and which fail. I have always advocated the use of cash for investing to reduce risk, reduce the amount of expenses caused by the use of financing, and because I am generally averse to the idea of owing money to others. This is a very conservative view, and I have regularlly been reminded by clients, peers and colleagues that with great risk comes great rewards. I had a sinking feeling that this sentiment was not always true and my experience drove me to create this analysis. It is by no means, a light read, or even an easy thing to grasp. I have attempted to remove my bias about cash investing from my writing, but it may very well show. After all, I started this project in an attempt to prove that cash investors make more money in the long run by avoiding the cost of financing. Read the analysis below and look at the lifetime breakdowns to see if I was correct.

My work with property managment firms, reviewing the results of my clients investments, and owning rental real estate personally have allowed me to become very intimate with the subject. It is my goal to share the knowledge I have obtained, and the results of my in-depth analysis with you. Enjoy!

Inflation Averse
The value of almost all items bought and sold rise with inflation. Inflation has been removed from all calculations to allow a ‘today’s dollars’ analysis to be completed. This type of analysis allows the user to make decisions based on how much it cost to live in today’s terms over a long planning period.

Adjustable Factors
In the ‘Details’ section you are able to make changes to specific variables, which will carry across to all three models as long as you are in the same session. Much of the information below will not be accurate after you make changes. The same general ideas and conclusions should remain the same. I suggested that you read the material and review the sheets before making changes to the variables. If you leave this website, all factors will be changed back to the original numbers.

Common Factors
When attempting to compare and contrast differing styles it is important to set as many variables to be equal as possible. This allows us to compare only the items that are significantly different. In this discussion there are several base factors that are equal across all three models.

• All investors begin working at age 25 (assumed to be professionals that went to college). This is the same age that they begin saving to invest in rental real estate.
• All investors earn the same wage starting at 50k per year, increase at the same rate of 5% per year, and cap out at a maximum of 150k per year. All investors stop working at age 60. This may not seem terribly realistic, but over a lifetime of work the averages are comparable to actual professional wages.
• All investors are purchasing the same type of property. This property was worth 100k in their 25th year. Generally, this is based on a single family residence in a decent part of town. For the investors that use financing they will always be purchasing the properties with 20% down using a fixed 7% 30 year mortgage. All investors pay 5% in closing costs on their transactions. All investors stop purchasing rental real estate at age 65, but retain their current portfolios.
• All investors are subject to the same market forces. The market value of the property that they are buying changes from year to year based on a 10 year cycle of increasing by 4% for the first 4 years, then decreasing by 3% for 3 years, then increasing by 1% per year for 3 years. The cycle repeats every 10 years for the life of the analysis. This yields an average 1.28% increase per year in the market value of the 100k property. There will be more discussion about these facts later.
• All investors are assumed to study the market and be aware of when the market is rising and falling. Investors will not buy real estate after the 2nd boom year, and will not begin buying real estate again until the second year of the falling market. The general idea is that they mostly buy when prices are low, and stop buying when prices are high.
• All investors buy their rental real estate for the purposes of holding for a long period of time. The purpose is to provide both cash flow and appreciation. The cash flow for all investors are based on annual income equal to 11% of the purchase price, expenses of 30% of gross rental income, and mortgages based on the actual amortization. No rental real estate is ever sold.
• All investors earn an average of 2.5% interest on their savings accounts, which is made up of all excess monies.
• All Investors use 75% of their post tax money to support their household up to a maximum of 75k per year. This is known as their household budget, or household spending.
• All investors are subject to the same tax rates of 10%, 15%, 28%, 33%, and 35% based on their annual taxable income which changes per investor from year to year.

General Investing Principles
Investing in rental real estate is valuable part of any good portfolio. How do you buy real estate? When is the right time in your investing carrier and lifetime to start investing in real estate? What type of property should you buy? How much should you pay? All of these questions are the reason why most people do not invest in real estate other than their personal home. In most cases since the home is viewed as personal most home buyers do not consider all of the previously stated questions as factors in their home purchase. If you do not ask investing questions when you buy a personal home, is it really an investment? Well, it is still an investment since it is an asset, but it may very well be worth less than the original purchase price when you are ready to sell if you did not get a good price or buy at the right time.

Rental real estate can be aquired as a part of two investment plans; buy and hold, and buy and sell (short term flipping). The buy and hold investor should be looking for low purchase prices to maximize appreciation, and cash flow potential. Buy and sell investors are also looking for deflated prices on properties they normally do not intend to hold for a long period of time. There are many ways to structure a flipping investment model but generally, they would want to buy it for a low price, fix it up if neccessary (commonly this is where a lot of the profit is made) and then sell at a later time for a significant profit. The recovered investment and profits would then be used to do another deal.

Flipping, as most short term investments, is very volatile, time consuming, and is normally not for the passive or untrained investor. Most successful flipping models require highly skilled real estate and construction professionals to be involved in the process of selecting, inspecting, buying, repairing, and selling properties. The inclusion of all of these different types of professionals, normally in some kind of profit sharing, or bulk work agreement allows the investor and partners to make more profit from property to property by controlling costs and picking great deals. Often even professionals fail in flipping investments. This paper does not intend to discuss flipping at length, but it is important to know that it exists and is not for most investors.

So what is a buy and hold rental real estate strategy look like? The potential investor identifies the type of property that he would like to invest in (single-family, duplexes, fourplexes, large complexes), researches the going rate of such properties per squarefoot, looks at several properties that fit the criteria, assesses their cash flow, assesses the market as to whether the current price is higher or lower than it 'should' be, makes a selection and purchases the property. For the purposes of all of the models, the investors are purchasing single family residences, which they would attemp to find a tenant for. The tenant would pay rent to the owner, the owner would pay all of the associated expenses of the property (property taxes, insurance, maintenance, and possibly a mortgage). The net difference between the rent collected from the tenant and the expenses(including mortgage) is the cash flow of the property. This cycle continues till the owner has to offload the property for some reason. The owner can continue to add properties to his portfolio and if structured properly should get more appreciation and more cash flow from each property he aquires. If it is structured properly then the owner should have a long-term assets that increase in value, and an annual cash flow from the investment properties.

Appreciation of Rental Real Estate
In the preparation of these models one of the hardest things to determine was the appreciation rate of real estate. After much research I used two pieces of information that were both very useful. The first was a graph of non-inflated housing prices published in the New York Times that tracked the market from 1890 to 2009. This graph was linked to many sites that I encountered in my research. This graph was mostly used to generate the 10 year cycle for all of my models. The cycle follows the general ups and downs of the 1970's and 1980's market booms. The rest of the information on the graph is very interesting, but mostly just helped me gain an understanding of market trends over a long period of time. The Case-Shiller index model was also a great help as it tracked the purchase and sale of specific homes over a long period of time. The topic of pricing indexes and appreciation of real estate is an enourmous one on its own, and this paper does not intend to discuss it at length.

The end result of my research on the matter was that a conservative long term average appreciation rate of real estate was 1.9%. You can see from the previous graph that there are major fluctuations within this. If you happen to buy in a valley and sell in a boom the property could have effectivly appreciated 100% due to timing and market conditions. While the intent of the investors in this model are to buy and hold, the end result is to own an investment that increases in value, and provides cash flow. The main purpose of this section is to address the appreciation of investment real estate as an end goal. Even if we inflate the conservative 1.9% to 6% (over 300% increase) buying real estate just for appreciation is not an effective long term investment. The effective annual appreciation represented in the models I have presented is 1.28%. The yeild of the investors in each model is slightly different because they often buy in valleys (when the prices are down). Attempting to buy low, hold for appreciation due to market forces, and then sell when prices are high over a lifetime (known as flipping) is akin to playing the stock market. It is highly volatile, time consuming, and has a lot of downsides.

Many investors that attempt to time their purchases and sales to get major short term (over the course of 2-5 years) gains due to the fluctuation in market demand fail and/or take huge losses. We have all heard the story of so and so who bought such and such, and then a few years later sold it for a huge profit. These stories are the very reason that unsofisticated investors attempt this flipping model. Over a lifetime the buy and hold investor will get much lower average appreciation, but are subject to a lot less risk since they are not attempting to time the market, which is very speculative.

Appreciation of real estate for buy and hold investors generally does not provide enough return in the long run to be the sole reason for investing in real estate. There are still cash flow and tax consequences to explore.

Cash Flow from Rental Real Estate
So we know that appreciation alone is not a good indicator of why real estate is a good long term investment. However, if you consider the cash flow produced by the rental investment in addition to the appreciation rate, then you should have a great investment (as long as the purchases are structured properly). In all of our models the cash flow is calculated at the time of purchase (because we do not consider inflation the number never has to change) and only changed when the mortgage term ends (the mortgage is paid off).

In the case of Subject 1 - Financing Buyer his first property is purchased at age 30 for 105,838 (plus closing costs), and it produces 1,390 in net cash flow annually after expenses and mortgage payments. This calculates to an additional 1.25% return on investment per year. The 1.28% appreciation plus the 1.25% annual cash flow return is still lower than the return on some money market accounts.

However, Subject 2- Cash Buyer purchases his first investment property at age 32 for 103,690 (plus closing costs) and because it does not have a mortgage it produces 7,984 in cash flow per year, which is an additional 7.33% return on investment per year. Together with the appreciation it is a healthy 8.61% per year average return. This is still not as high as the average 9%-12% return that most professional financial advisors claim to be able to net on a stock portfolio. In addition, if you consider the tax consequences of the cash flows for cash buyers the net after tax cash flow yeilds an even lower return by about 1.5%.

This all sounds very negative, but the point is that the cash flow of the investment purchased should be a major consideration in the decision to purchase a property, or to invest in real estate at all. The upside, which is addressed throughout this paper is that, while the return on rental real estate is lower than what most financial advisors claim to be able to produce on a stock portfolio, it is much less volatile if the purchases are properly researched and carefully structured prior to purchase. A stock can have negative returns and the prices can drop below the purchase price in an instant (literally), but the value of real estate rarely drops below the purchase price if it is purchased at the right time.

The cash flow of a property, expenses, repair costs, and mortgage payments can easily be calculated in advance of a purchase, and should be one of the most important factors involved in the decision to purchase an investment property.

Tax Benefits
The main tax benefit of owning an investment property is the ability to write-off (deduct from taxable income) depreciation. Depreciation is the systematic reduction in value of an item due to obselesence. Properties really do depreciate, meaning over a period of time they become worth less as they deteriorate, but this is recovered by the maintenance that the owner performs on the property. The cost of the maintenance performed on the property is also deductible, thus the depreciation is almost a completely free deduction to the investor. The value to the investor can be seen in the difference between the 'Rental Cash Flow', and 'Rental Taxable Income' columns on the subjects lifetime breakdown. For the cash investor in every case the 'Rental Taxable Income' is lower than the 'Rental Cash Flow'. However, as the depreciation period(29.5 years) ends, the cash flow and taxable income will become equal.

If an investor decides to finance their property the interest paid on the mortgage is also deductible, and in many cases the amounts paid are so high that the taxable income can actually be reduced to below zero, providing tax savings and net operating losses (NOL's) that actually save the investor money in taxes they do not have to pay.

The tax model used in the subject breakdowns is the actual income and tax bracket model used by the IRS. In addition, the interest deduction for financing buyer is actually ammortized each year to ensure that the tax calculated is accurate. The 'Rental Net After Tax Cash Flow' column is the actual cash value of the investment property cash flows net of taxes. There is a specific cash flow, which is the net amount of money left from renatl operations (gross rents - expenses - mortgage payments) that amount is adjusted by the net tax effect of the taxable rental income. If the taxable rental income is possitive then some tax must be paid on it and the net after tax cash flow is reduced by the amount of tax associated with the taxable rental income. If the taxable rental income is negative then the net after tax cash flow is actually higher than the original cash flow because there is a tax savings.

Investors who use financing pay less tax over their lifetime (14.3%) than the cash investor (16%) because they have more deductions associated with the cost of financing. There is a tax benefit to using financing to purchase investment real estate, but that savings is only a portion of the actual cost of financing. So while they save money paid in taxes they actually lose money paid in finance charges.

Real Estate Investment Risk Factors
There are three risks associated with investing in real estate.
1. The risk that the property will lose market value to an amount less than the original purchase price. This risk can be mitigated by buying low in down markets, and by continuing to hold an undervalued property till the market changes favorably. The rising and falling of the value of investments is inherent to investments of all types, whether it be stocks and bonds, investments in business ventures or rental real estate. Generally, real estate investments are less likely to fall below base market prices, which normally only occurs due to major events like the great depression, WWII, and 9/11.

2. The risk of damage to the property that would cost additional money to fix, and/or that would render the investment uninhabitable thus causing a loss of revenue, without an adjustment to the associated expenses. Generally this relates to major repairs (foundation problems, roof falling in, ect) and fire loss. This type of risk can be mitigated by the proper use of insurance for major claims. Stocks and bonds can be much more volatile than real estate in that their value can change dramatically from day to day. Real esate prices generally do not change quickly, but since they are a physical object they can be destroyed.

3. The risk that a lack of cash flow on a financed property will cause the owner to breach their puchase agreement, and thus the loss (foreclosure, forced sale, deed in luie) of the property. This can be due to vacancy issues, loss of personal income, and other failed investments. Rental real estate investments cannot all be treated in a bubble. When an investor has a portfolio of properties (multiple properties), cash flow from successful properties may be needed to feed the properties that have negative cash flow. If there are not enough successful properties in the investors portfolio they may need to supplement the investment with additional cash infusions from their personal bank accounts. If there is an interuption in the owners personal cash flow in addition to an interuptions in the cash flow of the real estate investments (of the real esate was originally purchased under a faulty model that did not generate cash flow), the outcome can be catestrophic. In the two models presented the investors purchase as many properties as they can. The more properties you have (if structured and managed properly) should mitigate the risk of financial interuption. You will notice that every rental purchased in both models has possitive cash flow, even when financing is used. This is what I mean when I refer to a proper model or proper structuring. Purchasing an investment that has negative cash flow is generally not a good investment. It is important to note that cash buyers rarely have to fear this risk, since generally the operating expenses of a rental are much easier to cash flow without a mortgage. In addition a cash buyer has no leins against their properties and may always sell, or leverage them to mitigate their losses.

Why Real Estate Instead of Stocks and Mutual Funds?
As stated previously, real estate investments are just one part of a long term investing strategy. Generally, a balanced long-term investment strategy includes tax deferred investments accounts invested in stocks and mutuals funds, and real estate investments. Sophisticated investors take a more hands on approach and commonly also have direct ownership investments in private businesses. Sometimes these are active investments like partnerships or cooperatives, and sometimes they are passive investments, basically loaning money to businesses and receiving divideds from the investment with no management duties. Investments in private businesses are very risky, and generally give great returns or net losses up to the investors original investment. Generally, you cannot lose more than you put in. This why these types of investments are for sophisticated investors that have done their research or know a lot about the business they are investing in.

I generally recommend that my clients begin their investing carriers by making a smart purchase on a personal residence (beginner home) that can be sold later or converted to a rental when they trade up. Step two is to begin putting money in tax deferred retirement accounts (IRA's, or 401k). I usually recommend that the investments in these accounts be managed by a professional and not by the client personally. Step three is to save up money to either invest in additional rental real estate investments, start a company of their own, or invest in other companies. This is a balanced diversified long-term investment strategy.

So the short answer is not real estate instead of stocks and mutual funds, but both plus a little more if you make it that far. As previously stated, the risks associated with stock ownership is that they can fall below the origianl purchase price very quickly and the original investment can be lost. This is very rare with real estate investments. The stock market is very sensitive to economic and other changes. Unless you plan to do it as a job it is generally not a great idea to get involved in managing you own stock portfolio. This is not true for real estate. It is much easier to learn how to manage real estate than a stock portfolio. The are many resources available for free to the beginner on the Department of Real Estate's website that will get you started and you can purchase books and subscriptions that will help you get better at it. While the stock market is the way that most people invest for the future (whether they know it or not, where do you think your company puts your 401k or pension contributions), investment real estate is commonly overlooked.

Return on Investment (ROI)
These models deal with serious long-term INVESTORS. An investor should be sophisticated, meaning that they know a lot and consider many of the details in any investments they make. The investors in these models are clearly sophisticated because they have a model that always generates cash flow and in the end they always get a positive return on their investment. The return on an investment formula is the total of all cash flows and the total of all appreciation on their properties. If we divide the total return on investment by the total money invested (total purchase price of all properties) we get the ROI percentage. If we divide the ROI by the number of years the investor has been involved in the a specific investment then we get the average annual ROI percentage. This is very important because it allows us to compare the specific investment to the standard yeild on other types of investments. All investors should consider the return on their investments. This tells tells them if they have been successful in their investments and also how successful they have been. Note: When looking at real life ROI you must consider inflation. In real life ROI must be reduced by the amount of inflation for the given years or period of time being analyzed. If you get a 12% ROI in a given year, but inflation was 3.5%(not uncommon) then you have to consider that some of your gain was merely due to inflation.

I have added one other item that needs to be considered in the overall analysis of which model is 'better'. How many man hours does it take to manage the investment (assuming the investors are managing the investment themselves)? When you work for an hourly wage it is easy to know what your hourly return is. With an investment it is important to look at it retroactively and consider how much time you spend managing your investment, and what your ROI per hour is. With rental real estate investments it is even more important because unlike most investments, they commonly require active participation in the monthly processing of rents, following up on delinquencies, collecting late fees, managing repairs, and paying bills. For the purposes of this analysis I have set the amount of time spent each month for each property owned at 30 minutes. This is based on my experience, but even if the numbers are lowered or raised it should not change the general conclusions reached.

Which Investment Model is Better?
Generally you would assume that Subject 1 - Financing Buyer is more successful because their net worth (shown at the very bottom of each lifetime breakdown in the lower right) is nearly 3 times higher than the cash buyer but there are a lot more factors to consider. After all investors want to have a high net worth right? Well, yes, but the better question is what is the return on investment? At the bottom of the lifetime breakdown for each subject you will see a summary of lifetime calculations that sum everything up.

Subject 1 - Financing Buyer accumulates 73 properties and is spending 36.5 hours per month managing their rental real estate, almost one solid weeks worth of work. This is in contrast to Subject 2 - Cash Buyer who only aquires 17 properties and is spending 8.5 hours (one day) per month managing their portfolio. Does more properties, and more time equate to more profit. No! While the finance buyer aquires a net worth of 12.35 million their ROI, which is total cash flow plus total appreciation of their properties is 4.4 million or a 44.18% return. Sound good? It is not, they invested for 50 years from age 30 to 80 (when we stop calculating) which gives then an annual average ROI of less than 1%. Some addional info is that they earn approximately 4 times less per hour on their investments than the cash buyer.

Subject 2 - Cash buyer has a portfolio worth 3 times less than the financing buyer, but spends less time managing their portfolio and gets much higher returns for that cash invested and their time invested. But the financing buyer gets richer you say!? Yes they have accumulated much more money, but at a much lower efficiency, and at a greater cost in time, and while exposed to much more risk through use of leverage.

The end result is that greater risk through financing does not bring greater rewards, and the smaller portfolio of the cash investor built slower over time exceeds the earning potential of the financing buyer. In addition, all of the differences are directly realted to the difference in cost of financing that the financing buyer experiences due to his choice to use leverage. The use of the Retern on Investment calculation says everything. Please take some time and review the lifetime breakdowns, and play with changing the figures on the details page (in case you think my preselected variables are incorrect).

Thank you for taking the time to read this. If you have any questions or comments I would be happy to review them Richard Bowen, CPA.

Additional Issues to Consider
In our current market it is getting increasingly more difficult to finance investment properties without the proper amount of upfront capitol. By using cash you can bypass all of the financiers restrictions. In addition to financing properties with cash down, some investors have had problems financing more than 4 properties with the same bank, even if they have 20% down and good appraisals. Investors who use financing for their purchasing models commonly have to find creative ways to keep the financed capitol coming in through lines of credit, 2nd mortgages, and revolving lines tied to their personal residences equity. Generally, dealing with bankers and financiers is a huge headache. If your business model relies on it then expect to spend a lot of time wondering 'What the heck are they thinking?' I toyed with the idea of adding an additional amount of time spent per property to the financing investor calculations due to the continual work related to securing and maintaining financing, but eventually abandoned it because I wanted to keep the two as comparable as possible.

Property management services are an extremely powerful tool in the arsenal of the unsophisticated or passive investor. Property management service companies enter into an agency contract with the property owner (investor) and agree to collect rents, pay expenses and mortgages, manage tenants, do maintenance, and report to the owner for a percentage of the gross rents (5% - 20%), or a flat fee. I entertained the idea of adding the cost of these services into the model as well since near retirement age both investors have so many properties that these services would be very helpful, but abandoned the idea for the same reason as above.

I have presented one of the main real estate investment models 'buy and hold' here. I discussed 'buy and sell' (flipping), but I wanted to mention that there are a plethora of other ways to invest in real estate. Real Estate Investment Trusts (REIT's), which are similar to a mutual fund in that it is a passive investment but all of the money of many investors are used to purchase real estate. There is also a trading-up model, which will likely spawn another program like this one, where the investor starts by purchasing several single family/duplex/fourplex properties, then later when the market allows they sell everything, sometimes as a group, and move up to either complexes (usually 10 or more units on one property), or commercial properties. Generally, complexes require a lot more work, but can have much higher cash flows if structured properly. Commercial property investments may be some of the most lucrative, because they are commonly triple-net, meaning that the tenants pay almost all of the expenses, thus leaving all of the cash flow to the investor. Commercial properties commonly have 5 to 10 year leases, which is essentially guarunteed contract income. While trading-up to bigger and better properties does have a lot of advantages, the problem is the tax consequences involved with selling all of your properties and paying tax on the gain. This can seriouly eat up your a portion of your gain, but can be avoided through the use of a '1031 exchange'. Additional problems arise since businesses, which lease commercial space, are more subject to economic forces and trends, so while you might be flush for 10 years, you could have a 5 year stretch where a good number of your tenants cannot afford to pay their leases. Commercial tenants are generally harder to secure, and are slightly more volitile. If you have specific questions about one of these models or know of one that you feel should be mentioned please bring it to my attention.

Throughout this discussion I regularlly state, 'if structured properly', this means that all expenses, cost of financing and expected return on investment should be calculated conservatively before a purchase takes place and considered within the overall lifetime investing strategy. Most beginners do not know how to do this, or even what questions to ask. I suggest that you consult a professional CPA/attorney/real estate broker. Putting together a comprehensive retirement plan is very important and most people neglect it. The earlier you start planning for your retirement, generally the nicer your retirement is... so don't delay call a CPA!

Finally, Portfolio Property Management is located in Bakersfield, CA and is one of my clients. I work very closely with them in managing property finances and company operations. I would like to thank them for being so helpful in arriving at the averages I used for property income and expenses.