One of the Worst Ways to Invest
I work with a lot of investors and a lot of what I call ‘accidental investors’ - people who had no intention of becoming a real estate investor, but do so when they move and rent out their property because it ‘almost covers the mortgage’. I cringe when I hear that phrase.
They keep the property as a rental, not because it’s a smart investment, but because they have some emotional attachment to the home. They think if they can ‘almost cover the mortgage’, they will have a big profit down the road.
Now, don’t get me wrong, I’m a strong advocate for investing in real estate and have many friends and clients that are wealthy today because of their investments. However, there is a right way and a wrong way to invest in real estate.
Most investors I know invest primarily for cash flow and secondarily for appreciation. Smart investors know their numbers and only invest in a property if the numbers make sense. The whole point of investing is to make money.
The mistake accidental investors make is that they don’t take a full inventory of the costs involved and only focus on covering their mortgage payment. Here are a few other expenses that affect cash flow:
- Insurance. As an investor, you want to get landlord insurance to cover your increased risk exposure.
- Capital Expenditures (Cap Ex). Big ticket items like a new HVAC system. For a condo, these will be less than a single family home.
- Repairs. The cost of the plumber you call on Saturday night fits into this category.
- Property Taxes.
- Condo/HOA Fees.
- Property management. Some people prefer to self-manage their own properties. That’s fine but just remember your time is worth something.
- Vacancy. This is a big one that is easily overlooked. Several weeks of vacancy can really eat in to your return.
- Real estate commission. Unless you are going to find your own tenants and screen them, you will be hiring an agent to help you here.
- Legal fees. Evicting a problem tenant has associated costs too.
So let’s use some real world numbers and see what the return is. Let’s assume you bought a 1BR condo in Clarendon a few years ago for $425,000 and put 20% down at the time with a 4.0%, 30 yr fixed mortgage. Let’s also assume it is worth $450,000 today and you could rent it for $2,100/month.
The Principal & Interest payment (i.e. the mortgage payment) is $1,623. So, after you pay your mortgage, you have $477 remaining each month. Not bad, right? Wrong !
Lets add in the other numbers smart investor use in their calculations:
- Insurance: $25/mon
- Condo Fee: $330/mon
- Property Taxes: $358/mon
- Cap Ex: 2%
- Repairs & Maintenance: 2%
- Vacancy: 5%
- Management: 8%
For future assumptions, we will use 3% annual growth for income, appreciation and expenses and a 6% sales expense.
The result: a negative cash flow of -$593 per month and cash-on-cash return on investment of -8.38%.
You can see the full report for this example here.
Even after 15 years, you would have a projected negative cash flow of -$789 per month and a cash on cash ROI of -0.93%.
Would you make an investment in an asset that would cost you money each month! I wouldn't either. Yet, I see plenty of people do it every day without realizing it.
To be fair, I didn’t factor in the tax savings since that will vary with each individual and the new tax law has many changes that people are still trying to figure out.
I also didn’t factor in any expenses for finding new tenants (real estate commissions or advertising costs). If you’re lucky, you will have the same tenant for many years. I recently met a landlord that has had the same tenant for 28 years!
Cash-on-cash return on investment (or simply Cash-on-Cash) is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage. It is often used to evaluate the cash flow from income-producing assets.
Total Return On Investment (or simply ROI) measures the amount of return on an investment relative to the investment's cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.
Cash flow is the primary consideration but it is not the only thing to consider. Here are a few more things to ponder:
Return on Investment
The total return on investment is different than the cash on cash return mentioned above. The total ROI takes into account the equity you build up over time. This assumes the property value appreciates over time and you don't have an interest-only loan. Many investors learned the hard way not too long ago (2006-2012) that real estate doesn’t always appreciate and some say we might be heading into another market correction. If you have positive cash flow, you can ride out any downturn and wait for the market to return.
If you ever meet an investor that says he never lost money on a real estate deal, he or she is either lying or they never sold their property - because they had positive cash flow and did not need to sell.
Capital Gains Taxes
A lot of people gripe about the tax code, but one provision homeowners love is the capital gains exclusion on the sale of your primary residence. Normally, if you sell real estate and make a profit, you have to pay capital gains tax on the sale, up to 20% depending on your tax bracket. However, if you lived in the property 2 out of the last 5 years, you can exclude up to $250,000 (or $500,000 if married and filing jointly) from capital gains tax.
For example, if you were fortunate to buy a property in the early 2000’s for say $200,000 and that you can sell that property now for $450,000, you would pay zero capital gains tax if you lived there two out of the last five years ($450,000 - $200,000 = $250,000, the max amount you can exclude as a single filer).
Now, if you had turned that property into an investment property over the years and did not live in two out of the last five years (yes, you can rent it out for years and then move back in to benefit from the exclusion), your gain would be $250,000 and you could be looking at a capital gains tax of $250,000 * 20% = $50,000 !!
Note: I’m not a CPA so either consult one for more guidance and/or read the IRS rules on the topic.
Can you handle tenants?
Are you willing to be a landlord? Not everyone is cut out for the life. Many tenants are easy to manage, but it only takes one nasty, non-rent paying tenant that you have to evict to change your perception. Of course, you can budget for a property manager and leave the headaches for them.
So, should you rent or sell your property?
I’ve only touched on some of the main considerations for investing, but everyone’s situation is unique and there are more things to consider. If you would like to discuss your situation, don’t hesitate to reach out to me.
If you would like a custom report (like the sample here) run for your property, enter your info in the form below.
