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Appreciation Is A Luxury – Invest Accordingly

Here’s an example, using real properties recently purchased by real clients. I’m gonna modify some of the numbers, but the modifications will not in any way make the bottom line better by an inch. (Worse in fact.)

What if you paid $245,000 apiece for four properties, each with an annual gross scheduled income of $28,800. The renters sign year long leases, and tend to stay a little longer than two years. We’ll set the operating expenses and vacancies at just under 40% — $10,950 a year. This results, when using currently available loans, in a negligible cash flow of less than $250 monthly — essentially a break even.

The down payment used will be 20%, though I’ll use 22% for any return figures. In these transactions you’ll be credited up to 2% of the sales price for your closing costs. The first year’s cash flow will be just under $3,000 or so for each property. We’ll assume any increases in expenses will serve to cancel out any rent increases. The loans are fixed rate, amortizing over 30 years, with a 6.5% interest rate.

If in five years the value is still $245,000 — what will you have gained? Of course, you didn’t invest to find yourself in a non-appreciating asset. Since your crystal ball is in the shop, we’ll just consider it your time in Murphy’s barrel. :)

So, what will you have gained in this scenario?

  • Income tax savings of around $7,500 a year, or $37,600 over 5 years
  • After tax cash flow of almost $12,000 annually, or $59,800 over 5 years
  • Principal reduction of just over $50,000 over 5 year holding period
  • It took about $54,000 +/- to close each of the four purchases, meaning you’ve invested a total of $216,000. In 5 years without values increasing, here’s what happened.

    Add up your 5 year total for tax savings — $37,600. Your after tax cash flow for the same period is a couple hundred less than $60,000. What that means to you is simple. Your Levi’s garnered just under $20,000 ($19,520) annually in spendable cash. That’s an after tax cash on cash return of roughly 9%.

    You also owe about $50,000 less than the day you closed escrow. Let’s look at what you might’ve done, if the after tax income was expendable for you.

    If you’d taken most of that after tax cash flow, say $18,000 a year, and applied it monthly to your loans, your total loan balance for all four loans combined, would’ve been only about $77,500 at the end of the holding period. If you did it for just another 31 months, you’d own all four properties free & clear. The income would be, give or take, $18,000 a year apiece — before depreciation.

    Your after tax income would run around $62,000 a year. You would’ve created this without a dime of appreciation — or a dime outa your own pocket. Not bad for less than eight years, would you agree?

    This is only to illustrate what’s possible for those of you wondering about your retirement. If you now have that $216,000 in capital this illustration is to demonstrate something I was taught when I first made the transition from homes to investments.

    Appreciation is a luxury — period — end of sentence. If you go into every real estate investment with that axiom in mind, you’ll be changin’ the way you analyze and acquire property.

    For those of you who’ve been decimated via your 401K or similar plan, this is a potential lifeline. Could things go wrong down the line? Absitively. Could those numbers be affected negatively? Yep. But they’re fairly conservative as used. Even if we apply what I’ve called the Vanderwell Rule — cut it in half and see if it’s still attractive.

    If you could invest $216,000 today and end up with 36,000 in before AND after tax income, half of what would be the most likely scenario, would you be OK with that? Your original capital would’ve more than quadrupled — in less than eight years. The after tax income at that point would be over a 16% yield on the original capital — again, using only half the most likely scenario.

    And all without any appreciation whatsoever.

    Something to chew on while perusing your latest 401K statement.

    Related posts:
  • Capture Appreciation and Cash Flow
  • What Happens to the Early Worm?
  • How to make money banking on the West Valley real estate market . . .

  • 8 comments

    8 Comments so far

    1. Ashlee December 29th, 2009 9:18 pm

      Great post with lots of great information. Def. something to sit down and think about!

    2. Ken brand December 30th, 2009 7:02 am

      Sweet, succinct and eye opening. I’m a residential guy, but I’m gonna share this and point investors to you. Cheers.

    3. Robert Worthington December 30th, 2009 7:04 am

      Hey Jeff. You could be the instructor at the next CCIM course I attend!

    4. Jeff Brown December 30th, 2009 8:23 am

      Ashlee — Much thanks.

      Ken — The ‘pointing’ will be mutual. :) Thanks

      Robert — The CCIM instructors, hands down, were the best teachers I ever had for the nuts and bolts of analysis. Good luck at your next class.

    5. Brent January 5th, 2010 7:46 am

      Jeff,

      You lost me on this part:

      “If you’d taken most of that after tax cash flow, say $18,000 a year, and applied it monthly to your loans, your total loan balance for all four loans combined, would’ve been only about $77,500 at the end of the holding period. If you did it for just another 31 months, you’d own all four properties free & clear.”

      When I run an amortization schedule on principal of $764,000, interest rate of 6.5%, and and extra $1,500 per month ($18,000 per year) in principal payment, I show a remaining balance approximately $609,000 at the end of 5 years. Obviously, this is far more than $77,500.

      Am I missing something here?

      Thanks,
      Brent

    6. Jeff Brown January 5th, 2010 8:15 am

      Brent — Mea freakin’ culpa! New BawldGuy Rule: No use of the HP 12C while on sinus medication. :)

      Instead of about eight years, it’s about 16 years that the four props become free & clear. You are absolutely correct. I showed your email to my in-house soft personnel. Her only comment? ‘Idiot’. :)

      The concept remains the same, as the results happen quickly, relatively speaking, especially when we consider the spirit crushing losses incurred by so many 401(k) owners.

      Thanks for bringing this to my attention — and thanks for not, perhaps righteously, renaming me BawldIdiot. :) When the label on the medication says don’t drive, from now on I’m gonna read: ‘and don’t compute either’.

      If my son sees this, I’ll never live it down.

    7. Brent January 6th, 2010 6:10 am

      Jeff – We all have our off days. Keep your chin up! Also, your son won’t hear about this from me.

    8. Jeff Brown January 6th, 2010 9:42 am

      :) Thanks Brent. One of the best days of my life was when I stopped tryin’ to protect my ‘perfect’ record. Have a good one.