Can you spot the tiny rental?
Real estate is all about asymmetric risk and reward. When the government gives you subsidies in the form of mortgage interest tax deductions and bails out overextended homeowners over and over again, you’d be silly not to invest in real estate! When you can invest lots of other people’s money and not have to split the proceeds if you make a killing, that’s a wonderful thing!
There’s a reason why every rich person you know owns multiple properties. There’s a reason why enormous fortunes have been made through real estate as well. How can Donald Trump still be a billionaire after declaring bankruptcy? Asymmetric risk and reward!
It’s no wonder property owners were once called lords, or now more colloquially, landlords. The wealthy own assets, while the not-so-wealthy lease assets. After 30 years of paying $2,000 a month in rent, your return on $720,000 is negative 100%. At least through a mortgage you’ve got an asset which you can live in rent free or pass on to your children once paid off. You might not make money as the downturn has certainly shown, but at least you have a chance.
When it comes to making money, if there is no risk, there is very little reward. After a lifetime of working, not owning might be one of the biggest risks of all!
EXAMPLE: BUILDING $400,000 THROUGH ONE PROPERTY
In early 2003, I put down 20% on a $580,000 condo with a mortgage payment of roughly $2,400 a month at 5.75%. I had just turned 26 and was nervous but adamant I didn’t want to pay more than $2,000 a month on rent. The $464,000 mortgage payment was split $500 to principal and $1,900 to interest. Rent for a comparable property at the time was $2,000 a month, so things were essentially a wash if you include property taxes and deductions.
Fast forward ten years later, the mortgage rate is now 3.375% thanks to several refinances on a loan of $285,000 (from $464,000). I’ve painlessly paid down $180,000 (39% of entire loan) in principal through my PMI loan and the occasional ad hoc principal payments. The mortgage is now just $1,300 with $500 of it going towards principal. Meanwhile, I’m renting the place out for $3,400 a month!
Mortgage interest not only dropped from $1,900 to $800 (-58%) during this time, rent went up from $2,000 to $3,400 (+70%). There are several reasons for this phenomena: 1) Supply is tight in San Francisco due to building restrictions on our 7 mile by 7 mile city, 2) Demand continues to rise due to an increase in jobs from new startups, 3) The economic crisis caused bonds to rise and yields to fall, and 4) The Federal Reserve continues to conduct very loose monetary policy. If you’ve ever deliberated between good location and higher prices or bad location and lower prices, consider the former.
The final positive is that my neighbor just sold his property for $780,00 last month, which is a 35% total return on the initial purchase price of $580,000. The cash on cash return on the $116,000 downpayment is a nice 172% ($200,000 / $116,000)! In other words, I got to live in my property for two years rent free, have someone else pay down about $60,000 in principal for me, and have an asset worth $200,000 more.
If I had no mortgage, the net operating income (NOI) is around $2,500 a month or $30,000 a year. You need $1,000,000 in the bank at 3% to generate $30,000 a year in this low interest rate environment. Not bad for an asset originally purchased for $580,000 don’t you think?
Note: The blue line is now around $3,200 in 2015 (off the charts, literally).
MORE REASONS WHY REAL ESTATE IS A GREAT ASSET
* Hedge against inflation. You only hate inflation if you don’t have an asset that is inflating. If you own an oil field, a private university, and organic farm, a gold mine, or a rental property, you are loving inflation! Inflation is increasing the prices of your goods hopefully faster than the input costs and the costs to operate your asset. You think rents and prices are expensive now, but I promise you they’ll look cheap 10 years from now.
* A money making play on inflation. Forget about protecting yourself against inflation. Owning real estate is a play on making money with inflation. If there so happens to be hyperinflation, your cash is devaluing rapidly as your real assets start surging in nominal value. Economic tightness will return sooner or later, causing another surge in property and rental prices.
* Generational wealth transfer. You can pass on property from generation to generation, conceivably making their lives a little bit better. Think about all the college graduates nowadays who are complaining they will never be able to afford a home like their parents due to exorbitant prices. Now think how much worse it will be for their children. If your parents happen to just give you one of their properties, life becomes much less stressful as you don’t need to pay rent anymore! You don’t have to study as hard to succeed either. You can pursue un-lucrative fields such as music, dance, and other fine arts if you so choose because those are your dreams.
* Little effort to build wealth. The most effort comes from researching the property you want to buy and finding the right tenants to pay your mortgage. Once you’ve run various scenario analysis and screened your applicants, you can basically set it and forget it. My average tenant turnover is 2.5 years. I host two open houses for 1.5 hours each, spend another two hours reviewing applicants, and another hour coordinating the move in and that’s it. Meanwhile, to turn $116,000 into $500,000 through equity investing is no easy feat, neither is saving another $384,000 over 7-8 years. The whole idea is to invest in assets that work for you, and not the other way around.
* Tax-free profits. The first $250,000 in profits for singles and $500,000 for couples is tax free if you live in your property for the last two years before sale! If you so happen to be in the top income tax bracket, this is absolutely music to your ears! In order to bank $250,000 in after-tax profits
as a top income tax bracket earner, you’ve got to make around $450,000 in gross profits. This special feature alone makes me want to buy property over and over again.
* Serves a utility function. Unlike cash, which serves no utility function, property addresses a fundamental human need, shelter. If our financial system goes to hell, at least you will have a tangible asset you can actually utilize. The only thing I can do with cash is make paper airplanes and perhaps start a fire.
* Almost dummy proof. There were a lot of people who didn’t understand the terms of their loans (neg am, balloon payments etc) or who borrowed way more than four times their income with no savings buffer. Good thing for you, you’re no dummy because you’re reading this article and other articles about real estate investing. Once you run the realistic cost and revenue numbers based on data provided by the seller and comparable properties, you have a base case assumption. If you are achieving a rental yield of 7% and can borrow at just 3.5% after a downturn, your month should be salivating for such a 3.5% immediate spread with principal appreciation potential.
* Measurable wealth. I know that after I finish paying off my rental property mortgage, my initial downpayment of $116,000 will be worth somewhere around $600,000-$1,000,000, depending on market conditions. When you invest in private equity, or even public equity, you are taking a massive leap off faith that management and other exogenous variables don’t crush your returns. You pretty much know what you’re going to get in real estate if you follow the course.
* Priceless feeling. There’s something nobody really tells you when you finally purchase your own home. Perhaps because that something is unquantifiable. Even though you likely won’t own the house outright in the beginning, it feels wonderful not to pay someone else’s mortgage anymore. It’s an amazing feeling to be the king or queen of your own castle where you can do what you please. So long as you pay your mortgage, nobody will ever be able to kick you out. You grow roots and finally gain conviction to launch your life.
RINSE, REPEAT, AND GET WEALTHY SLOWLY
During the two years of living in my now rental property, I saved aggressively in order to put down 20% on my next home. It had a year and a half of appreciation glory before the housing bubble collapsed. But now, the fever is back as my neighbor three doors down sold for 21% over asking after being on the market for just 11 days. The final sales price is 56% above what I purchased my house for seven and a half years ago. If I were to take a realistic comparison to account for the size differential, recent remodel, and quieter location on the block, I’d estimate his sales price values my house 20% higher than my purchase price. If you’ve seen the typical row houses in San Francisco, you know they are all quite similar.
Since purchase, I’ve cut my primary mortgage interest payments from initially 5% down to 2.625% by refinancing as often as possible (thank you BenGenie). Meanwhile, rent for my type of home has increased by about 25%. All this happened during the biggest economic collapse of our lifetimes! It’s not hard to continue living, paying the bills, refinancing, and focusing my efforts on building alternative income streams. Again, owning property is pretty dummy proof if you can hang on. Just make sure you run the numbers, create a realistic worst cast scenario, then run them again. Now I can’t wait for the relative calm over the next 10 years.
I didn’t buy my house with the primary hopes of creating more wealth. I bought my house because I didn’t want to live in an apartment anymore. I wanted my own deck, backyard, and freedom to turn up the home theatre system as loud as I wanted. At the age of 28, I wanted to start living a better life after slaving away in the office for the past six years. If I wanted to make more money through real estate, I would have bought a multi-unit building instead. Life can’t all be about making money. Funny how we like to justify our purchases.
Despite economic Armageddon, real estate is still my favorite asset class. For those who are under water, don’t give up hope because everything eventually comes back. Very few other assets require so little work and allow for so much outside funding to create so much value over time. Renting has its benefits, namely flexibility. But renting itself does not build any wealth. If you are considering investing your money that’s sitting in low yielding accounts, consider investing in real estate. It may be a tough slog the first two years, but in ten years, you’ll probably wish you had bought more!
RECOMMENDATIONS TO BUILD WEALTH
* Shop Around For A Mortgage: LendingTree Mortgage offers some of the lowest refinance rates today because they have a huge network of lenders to pull from. If you’re looking to buy a new home, get a HELOC, or refinance your existing mortgage, consider using LendingTree to get multiple offer comparisons in a matter of minutes. Interest rates are back down to ALL-TIME lows in 2015 due to tremendous volatility and uncertainty in the markets. The Fed is signaling interest rate hikes by 2016 due to inflationary pressures now. When banks compete, you win.
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After you link all your accounts, use their Retirement Planning Calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management.
Photo: Tiny home in Amsterdam, 2015.