There’s always something to howl about.

How to turn $1.00 into $27,000 in eight years . . .

That sounds like a late-night TV pitch, but it’s actually possible in residential real estate. Housing is distinct from other investment vehicles in important respects. Unlike securities, real estate is a hard asset with an enduring intrinsic value. There are huge tax benefits accruing from owning real property, either as an owner-occupant or an investor. Most significantly, real estate can be leveraged up to 100% of its value.

Yes, you can buy a home with “nothing down.” Through the masquerade of a seller concession, you can even roll the closing costs into the loan, so that you can take possession of a rental property with absolutely no money out of pocket.

Why would you want to do this? Because the purpose of investing your money in real estate is not to own it but to profit from it. Real estate investment books are filled with bad ideas — never buy a cash-flow negative property, buy the cheapest home you can find, buy four-plexes in challenged neighborhoods, pay ahead on your mortgage to increase your equity. These are all terrible ideas because your sole objective should be cash-on-cash return: How much money did you take out of your pocket at the start of the investment, and how much money did you put back into your pocket at the end.

Is a cash-flow positive property a bad thing? No, but a home that is cash-flow negative — if you can afford the negatives out of other sources of income — can be a much better cash-on-cash investment.

Buying cheap is usually a terrible idea. The money from real estate investing comes from appreciation, not rents. Unless you convert the property to a higher and better use, what starts cheap usually stays cheap.

In the same way, buying multi-family properties or other homes in bad neighborhoods is unlikely to be a winning strategy. Your ratio of rents to costs may be better, but your appreciation will almost certainly be worse than buying in a more-avidly-desired neighborhood.

And paying ahead on your mortgage is just dumb no matter where you buy. With a 100% leveraged property, every penny of appreciation is 100% cash-on-cash profit to you. If you have any excess cash, you should be using it to buy more properties.

So what kind of investment property do you want? In the Phoenix area, the best-performing rental homes are newer homes in highly-desired middle-class suburban subdivisions. Unless you put a huge amount down, the properties will surely be cash-flow negative. They will not be cheap — on the order of $200,000 to $250,000 right now. Obviously, we only want to buy single-family housing, because we want for our rental to be surrounded by owner-occupants, and because we want to sell to owner-occupants on the way out. And I don’t even want to think about paying ahead on the mortgage.

There are a lot of houses like this for sale right now. For the most part, the sellers aren’t desperate, but if you’re willing to shop, you can pick up a deal. Alternatively, you can buy a home subject to a lease in place, which solves your first problem as a landlord.

I’m representing a house like this right now — I’m doing another one on Thursday. The seller of the first house bought it in January of 2005 for $136,000. We’re selling it for $200,000, with the seller conceding back three percent for closing costs. His marketing costs plus closing costs on both sides will run to around eight percent, total, so his net on the home will be around $48,000 — after only twenty months in what people who don’t know any better insist is a terrible real estate market.

But we’re not worried about his money, we’re worried about yours. If we buy that house for nothing down, we’ll call your initial outlay $1.00. Your mama always told you can’t get something for nothing, and spreadsheets don’t like division by zero. We’ll pay 7% for the 80% first loan, 10% for the 20% second — your mileage may vary. That’s $15,200 a year in debt service. We’ll pay the real life numbers for taxes, insurance, maintenance and HOA fees: $2,428 a year. We’re going to collect $1,000 a month rent for the life of the investment, even though rents should go up. We’re going to hold vacancy at 10% even though it’s less than that now and is trending downward. In other words, we’re not going to kid ourselves about anything. These are real life numbers with no blue-sky assumptions.

Annual net income is $10,800, allowing for vacancy, while expenses are $17,628. Your negative cash flow before taxes is $6,828 — $569 a month negative cash flow. This is where the investment-book authors freak out, but think of this this way: If you had an IRA or some other paper investment, what would your monthly negative outflow be? Your goal is to own a leveraged asset that will produce the greatest possible cash-on-cash return. A tenant can offset some of your costs, but you will not make nearly as much money, cash-on-cash, on a cash-flow positive rental.

Here’s good news, though: At tax time, more than half that negative goes away in depreciation. If you have chattels in the house like a refrigerator, washer and dryer, those can be depreciated on an accelerated schedule, for even more tax benefits. You’re now down to about $274 a month in negative cash flow. If your spouse glares at you, I’ll be happy to explain why we’re doing this — as many times as necessary.

For the sake of this discussion, I’ve assumed a fairly soft long term rate of appreciation — five percent, where the Phoenix area has historically averaged six percent. The people who are convinced that the sky fell yesterday will not be moved, but the rate of appreciation matters a great deal in determining when we’re going to sell this house.

When would that be? When we get to the back side of the depreciation schedule. We can only depreciate 80% of the original purchase price, so, as the value of the home escalates, we lose some of the tax benefit of the asset: It’s worth $300,000, which should be worth $240,000 in depreciation, but, because we bought the home for $200,000, we’re only able to take $160,000 in depreciation. The point at which it becomes more profitable to sell and reinvest than to hold is bright-line determinable, and we should sell when we get to that point.

Let’s call it eight years. The property will be worth almost $300,000, and we’re going to have to pay taxes plus marketing costs of about six percent on the way out.

Net cash to the seller? $26,802 — after everything, including all the negative cash flow. How much did you put in? Oh, that’s right, a buck.

I don’t expect people to take me on faith. This entire scenario is documented in this spreadsheet. There is a lot more about investement strategy on our investments page. I have investors who have made hundreds of thousands of dollars in highly-leveraged real estate investments. A few are on track to become millionaires by investing other people’s money. And while no one can promise future appreciation, the residential real estate market in Phoenix — reports of its demise to the contrary — should be robust for a long time to come.

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