|Discussion of Model|
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 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!
General Investing Principles
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
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
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.
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
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?
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)
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?
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
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.