I’ve had a passion for real estate my entire life. When I travel for business or vacation, I spend considerable time looking at real estate (private homes, apartments, and hotels), contemplating the value of purchasing a property and making it available for rent. Until I started investing I didn’t understand the implications of making such a purchase, much less the real benefit of owning real estate.
Buy for Looks?
For myself, and 99% of all real estate investors, one compelling reason for investing is the pride of ownership. You can’t get around the fact that owning a physical asset gives you a sense of satisfaction that you can’t get from looking at a piece of paper that says you own 100 shares of a company’s stock.
I would never tell someone to buy a property because of its looks, but the reality is: I wouldn’t buy a property that I don’t find attractive. It’s my first qualification when looking at a property. It may be in a great location and a great price, but if I don’t like how it looks or feel it has the bones to make it look great, I’ll pass on it every time. You have to trust your judgment on what your customer wants. You may be able to get renters for an ugly house because of the location or a discounted rate, but you’ll almost always be the last to get the booking and will settle for lower occupancy. You’re more likely to talk about your property, share pictures and experiences with people, and ultimately be willing to continue investing in maintaining and improving the property if you are proud of it.
Ultimately, don’t make emotional decisions on the features of a property because, in the end, it’s still an asset and needs to work for you. You can be proud of your property and hang a picture of it on your wall, but unless it’s returning a profit, it’s not a good investment.
What constitutes a good investment?
Investors have different objectives. I know just as many passive investors as active; just as many expecting a 15% return as those wanting to park their money somewhere safe; certainly as many that won’t touch real estate as those investing in real estate exclusively. No matter your perspective, my intention in this article is to outline the benefits and describe some realistic expectations.
I’m going to use some terms such as CapRate and Cash-on-Cash. CapRate is essentially your rate of return, not including mortgage costs, capital expenses, and depreciation. Cash-on-Cash is a similar metric but takes into consideration mortgage costs. For more information on these and other investment terms, refer to my blog post: ‘What to Measure’.
The overall return and the value derived from real estate investing goes way beyond the rate of return described in a CapRate or Cash-on-Cash metric. Appreciation (equity gain) adds to your overall net worth, while depreciation reduces your taxable income. The net of your return can be multiple times higher than what’s described in a CapRate. Let’s walk through an example:
Example from a property I’ve purchased:
Purchase Price: $170,000
Operating Costs: $12,000
Net Operating Income: $18,000
CapRate: 10.5% ($18,000 / $170,000)
A 10.5% return on any investment is pretty respectable. But, when you utilize leverage (mortgage), the return can be even better. Let’s take a look:
Property Value: $170,000
Down Payment: 20% ($34,000)
Yearly Principal & Interest: $10,000
Here’s where the real value is recognized:
Cash-Flow after Mortgage: $8,000
Total Investment Amount: $34,000 (the amount of cash invested in the property)
Cash-on-Cash Return: 23.5% ($8,000 / $34,000)
A 23.5% return is very strong…for any investment! But we’re not done yet. You have to consider the fact that your renters are paying off your mortgage. At the end of your 30-year mortgage, your renters will have returned you another $136,000 (a little more than $4,500 a year). Over those 30 years, it’s not unrealistic to expect a 3% annual increase in property value. That would equate to an increase of $242,000 (over $8,000 a year).
Over 30 years, your total equity return would be $378,000. If you viewed that every year, along with your yearly cash-flow, that would equate to $20,500 per year and an annual return on your $34,000 investment of 60% per year.
OK – I know what you’re saying: I’m not taking into consideration the devaluing of the dollar over those 30 years. You’re absolutely right! But my calculation also doesn’t take into consideration a yearly increase in rents. I’m also not calculating the opportunity to compound that return by reinvesting the yearly income into another property. Within 5 years you can take your $8,000 cash-flow and purchase another property that now generates another $8,000 a year in cash-flow. Now with $16,000 of yearly cash-flow, you can purchase another property in a little over two years, increasing your cash-flow to $24,000. By year 9, you’ve purchased your fourth property, generating $32,000 a year and have positioned yourself to purchase a property every year going forward, increasing your yearly cash-flow by $8,000 per year. If you have the energy to reinvest your cash-flow for the first 15 years, you’ll have produced a yearly cash-flow of $120,000, purchased 11 properties and have the purchasing power to buy 3 properties a year. I think that’s enough evidence to say I don’t need to account for devaluing of the dollar when determining if the investment is a good deal.
But, it only gets better
I’d always heard tax advantages are a big reason for investing in real estate – and the fact that the legislators who create the tax laws own real estate, it would make sense. I’m a cash-flow (Value) investor, but increasing your net-worth through asset appreciation and reducing your taxable income through depreciation are major factors when investing. We’ve walked through the power of asset appreciation, now you’ll see where the benefit of depreciation allows you to utilize cash-flow with limited income tax liability.
Our use-case: $8,000 per year of cash-flow on a $170,000 property:
The depreciation on $170,000 would be a little over $6,100 per year (depreciation of $170,000 over 27.5 years). That reduces your yearly taxable income to $1,900. By year 15 we projected cash-flow to equal $120,000 per year. That level of income would have a tax rate of 22% for a married couple (as of 2019).
Tax liability before depreciation: $26,400
Tax liability after depreciation: $3,420 (qualifies as 12% tax rate)
That’s a savings of nearly $23,000 a year in taxes. That makes your $120,000 yearly cash-flow worth a taxable income of $153,846.
But, let’s be realistic
The example I provided is a real example and not an outlier. I have other properties that perform even better but were a bigger risk (for example: renovating an 80-year-old cabin in New Mexico). We have numerous investors with the same or higher return on their investments. But, I caution all potential real estate investors to perform their due diligence. Most investments do not cash-flow for the first 5 years and many don’t cash-flow at all. We specialize in cash-flow investments in the short-term rental market. You should consult the expertise of a property manager (commercial, residential, vacation rental, etc.) that can generate sufficient revenue to produce this type of result. There will be a cost associated with these services, but they typically pay for themselves with the added revenue and reduce your effort in managing the property so you can focus on investing.
Also to note, I’m not sure I’d recommend building such a large portfolio of single family short-term rental properties. There are limitations on the number of loans you can obtain, and from a scale perspective, commercial investing makes more sense. But for the purpose of understanding the value of real estate investments, this scenario helps describe the benefits.
As you evaluate properties, I’d suggest listening to the advice of Joe Fairless and follow the Three Immutable Laws of Real Estate Investing. 1) Buy for cash-flow; 2) Use Leverage; 3) Have Reserves. I’m a value investor and believe in only investing in cash-flow. It’s a safe/conservative approach, but as you can see can produce very strong equity returns and tax savings when implemented properly.
Why Short-Term Rentals instead of Long-Term Rentals
I’m obviously biased towards short-term rentals (STR). But my experience has shown a significantly higher level of return with STRs. Partially because the Long-Term Rental (LTR) market is flooded with professional and amateur investors competing for rates and occupancy with similar inventory (difficult to have a unique competitive advantage). In the STR market, there’s an opportunity to distinguish yourself from the crowd. Improved properties, professional hospitality, strong channel management, prompt customer service, and revenue management can produce 2-3x the revenue of your competition.
The challenge is managing STR’s is very operations heavy. For more details, check out my blog posts:
These should give you some insight into the operational requirements.