In September of 2018 I wrote blogs here
and here
outlining reasons I think dividend investing beats the socks off real estate
investing. This series digs deeper and demonstrates
how easy it is to lose a ton of money in rental real estate. (Seriously,
if paid in quarters it would be 215,612 quarters x .2 oz per quarter = 2,695
pounds or 1.25 tons!) You can achieve
this feat (fate?) if you keep reading and follow the instructions.
How does one achieve such a magnificent task? It took time and diligence, but I managed. Here begins the recipe for disaster that
unfolded over a decade.
To start, get caught up in how readily wealth can be created
through real estate. Oh, the magic. There are plenty of books to help you out. Don’t mistake wealth on paper for wealth in
the wallet. They’re not the same.
How to lose a ton of
cash on a rental property: Financial
Analysis:
Here’s how to go about mixing the unfortunate cocktail. Start with an excel spreadsheet and a little
imagination to develop a profitability model containing 4 ROI components within
the expected total return: net profit,
tax savings return, renter-paid principal reduction, and property value
appreciation. Work that model through
many gyrations until great riches are certain, line up the financing, and go
shopping.
Net Profit is easy
to explain. Receive $xxxx in rent then
pay $yyy in mortgage, operating expenses, and taxes. What’s left, presumably positive, is net
profit.
Do your market research on rent, but confine the search to
an area within roughly a half-mile radius of the target property. Determine that rent in the area for that type
of property is 20-35% higher than the expected bank note given some form of
creative financing. Do NOT under any circumstances
check on rental rates outside that radius and for the love of Mike don’t
investigate whether or not a builder is putting up a complex with similar
floorplans at lower price points within 1 or 2 miles.
Assume the property will be rented at least 11 months of
every twelve, on average, given projected rates of turnover. Bake in less than appropriate costs for
on-going maintenance and repairs assuming renters treat well a property they
don’t own. Also presume the property
won’t be held long and therefore large renovations won’t be a factor. Remember, in real estate expectations around
rental turnover and expenses can cause problems if set inappropriately. By all means, be inappropriate. For the purposes of this exercise, let’s say
the imputed Net Profit is 8% which is a nice return on your investment.
Depreciation-related Tax
Savings Return is what happens when a rental property is depreciated on a
straight line basis over 28.5 years.
Stir in this paper “loss” to offset some or all the cash earnings to
reduce your tax burden. Then consider
the taxes saved as a form of profit to grow the ROI. The added margin may be fairly small, but
might equate to a point or so in the total return model so add 1% to the 8% Net
above.
Throw a fistful of Renter-paid
Principal Reduction into the model.
This component is based on the premise that the renter actually pays
down the mortgage principal and not the borrower. In essence, the renter is paying into the
equity bucket. Those equity payments are
added to the net profit and tax savings items above to goose the ROI even
further.
In normal amortization tables, the principal portion of a
mortgage is a fairly low percentage of the total payment e.g., 15% during the
early years of a mortgage. However, the
principal paid by the renter can equal or exceed the net profit. When added to the model it bulks up the total
return by an impressive figure. Let’s
say the principal pay down component is equal to another 8%. Now the ROI equation includes 8% net profit +
1% tax savings + 8% in principal reduction for a 17% total return. And the good stuff lies ahead.
Finally, add expected property value appreciation to the
analysis. In a go-go market factoring in
5%+ compounded annually may be a conservative assumption.
If an investor bought a property for $120,000 with an annual
appreciation rate of 5%, he might expect to see the price climb to $126,000 at
the end of the first year. If the down
payment was $20,000, then a $6,000 increase in property value relative to the
$20,000 down adds another 30% to the return so include that in your formula for
riches. Tote up an ROI of 17% from the
previous 3 items then tack on a respectable 30% for a grand total return on
investment of 47% in year one. By now
you should see disaster brewing; if not, continue.
Conveniently forget or ignore the fact that financial
leverage cuts both ways. Deeply. The way the leverage is structured may
further spice your recipe. Forget that,
too. You’ll learn more in the long run.
Generally speaking ROI is calculated upon the capital put
into the deal and not the total deal value.
Therefore the smaller the down payment, the larger the ROI. This is the beauty of financial leverage. However, the ugly is out there, too. In spades.
Aim for the smallest down payment a creative lender can offer on a
rental and throttle anyone hollering Caveat Emptor in your presence.
With these ingredients, an impressive and completely
unrealistic total return on a rental property is within reach. The ROI can be further juiced with aforementioned
creative financing. There’s plenty out
there, just turn over a few rocks. A
fabricated ROI spun from this yarn makes wild profitability a near certainty,
at least on paper. With ignorance and
confidence success is assured. Right? Ignore the possibility that reality is waiting
in ambush with truth that doesn’t map to the Excel model. Easier done than said.
To summarize, begin the adventure playing monopoly with a
spreadsheet, get caught up in paper returns (profit, principal pay down, depreciation
tax savings, and property value appreciation) and do not focus on silly things
like real money. Cold. Hard.
Cash.
In the next post, I’ll discuss how creative financing widens
the money sinkhole.
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