Real Estate Investment

[Vishon]

I was sitting here at work making some calculations on real estate investments and found that under some conditions it gives great return.

If I bought an apartment for 180k, like this one ( http://www.sdlookup.com/MLS-076063815-15273_Maturin_Dr_28_San_Diego_CA_92127). Put down 20% (36,000), borrowing about 144k, at 6% 30year fix the monthly mortgage is about $870; property tax at 1.2% is $180/month, association of $141/month. The total carrying cost is about $1185, which is about how much it can be rented out for.

Assuming annual housing appreciation of 4%, the apartment will appreciate to $583k in 30 years. From the initial investment of $36k that’s about 9.8% annual return. At 7% annual housing appreciation, it’ll be 13% annual return.

Actually that calculation is not accurate enough, the monthly carrying cost of the apartment will be the same for fixed rate mortgage, but the rent will go up with appreciation, so the final yield is even higher.

Is there something wrong with my calculation? or is it really true that getting someone else to pay off the borrowed investment capital drastically increase the profit margin? It is like someone paying for the margin to buy stocks while the account holder is reaping all the profit…

[Anonymous]

Assuming annual housing appreciation of 4%, the apartment will appreciate to $583k in 30 years. From the initial investment of $36k that’s about 9.8% annual return. At 7% annual housing appreciation, it’ll be 13% annual return.

Will it bother you or mess with your calculations much if for the first few years (or very likely more than that) you receive negative appreciation? Have you factored in the time when your property will be unrented as well as the anoyance of being a landlord (repairs etc…)?

[4plexowner]

1) non-owner occupant won’t get 6% fixed mortgage – maybe 7.5% or have to buy down rate (or lie about occupancy)
2) you haven’t factored in maintenance – are you planning to maintain this apartment for 30 yrs or just let it go
3) you haven’t accounted for appreciation of the HOA fee – do you think it will stay fixed for 30 yrs?

Condos are the worst real estate investment you can make – possibly worse than mobile homes

There will come a day in San Diego when it makes sense to buy investment property again – today ain’t that day IMO

[surveyor]

ROE = (CF+AP+LR+TX)/DP

ROE=return on equity/investment
CF=cash flow
AP=appreciation
LR=loan reduction
TX=tax benefits
DP=downpayment

Using your example above (all numbers annualized and assuming 4% appreciation over TEN years)…

CF = (1185*12*0.95-(180+141)*12-2000-11496)=-3839 per year
CF = (yearly income* 5% vacancy rate – tax – assoc. – maintenance – amortized loan amount using 7% interest)

7% to 8% interest is normal for investment property. 6% is normal for owner occupied property. Also assuming that owner will be the property manager (property management fees would be an additional 10%*income hit to cash flow).

AP = (180000*0.04) = 7200

You can only use 4% appreciation if you are planning on holding the property for around 10 years. Otherwise you will have to calculate in 0% appreciation for the California market.

LR = 1562

TX = 180000/27.5*0.25 = 1636
TX = rough estimate! = (cost of property / 27.5 * tax rate)

Sooooooooooooooo….

ROE = (-3839 + 7200 + 1562 + 1636)/36000 = 18.2%

So by real estate terms, it is an ok investment. Cash flow sucks (as does everything in California). You’ll still come out ahead but that negative cash flow will be tough to maintain. Still 18.2% is a decent investment return unless you’re really good at picking stocks. Still there are hazards for owning property for ten years or more.

Most seasoned investors would not buy a property like this because of the negative $3839 cash flow per year ($-320 per month). Unless you are deliberating trying to decrease your taxes, probably not a good investment buy.

The cost of the property at which it would cash flow? $120k.

Anyways if you want to evaluate any property for its investment potential, use the calculation above. If a property goes to around 25% to 30% ROE, it is considered a good purchase (assuming optimal conditions!).

(is it lunch yet)….

[surveyor]

So to answer your question:

or is it really true that getting someone else to pay off the borrowed investment capital drastically increase the profit margin? It is like someone paying for the margin to buy stocks while the account holder is reaping all the profit…

Yes, someone is paying your expenses and you are reaping the appreciation/cash flow/tax advantages. This is generally called leverage and it is how real estate can be used as a powerful way to make money.

However, as the calculation above shows, it is not as easy as you think and it requires a lot of knowledge to do.

But your general premise is more or less correct.

[NotCranky]

I was hoping surveyor woudld appear. I usually put in gross amounts of sweat equity so would not be crunching the numbers from a turnkey start.

Like him I am condo-phobic. However,my two cents…This property could be approximating a good start for an owner occupied situation.(I didn’t study it much). This is for beginning investor, not rich guys. The idea is get a good entry price and take the lower rate and put less down and save the rest for better opportunities if they come up, maybe a detached house, keeping in mind most lenders factor rental income at .75(rent).

Lots of single and young couples do this just to get their own places and work on future housing from there. Condos normally have a bad reputation for appreciation.The really easy money and apparently the stigma of being a non- owner drove prices up ,not value because generally speaking(outside of manhattan) the value is in the dirt which condos have little of. Back to the point, eventually they cash flow better and better and the principal as you know, gets paid down. You keep it or sell based on market factors and your personal criteria.

If you are looking to add to or start a portfolio of rental properties I agree this is not a good start.

So what is a good start? Properties out of this market and markets like it, for the most part. Maybe out of state. I am sure you can wait for a bettter opportunity in SD and keep learning and eventually do O.K. here.

Best wishes

[SD Realtor]

Nice post Surveyor..

I would like to add, most if not all seasoned investors left Cali about 2 years ago and already purchased in North Carolina, Seattle and other markets that showed strong growth potential. Even as strong as North Carolina is right now, even the true experts will probably bail out of there in the next year or two.

No seasoned investor would touch California right now. However it would not surprise me if those top guns that have reaped growth in other markets come back to Cali in a few years when things pencil out again.

SD Realtor

[gn]

keeping in mind most lenders factor rental income at .75(rent)

Rustico, at one point in time I read in a real estate investment book (I think by Bob Irwin) that lenders factor rental income at 0.90 (rent). The 10% is for vacancy & maintenance.

Is the 25% (i.e. 0.75) a recent change (i.e. less than 5 years) ? Or my memory did not serve me correctly ?

[Vishon]

Very interesting. My calculation wasn’t precise enough. Thank you all for the feedbacks.

One question, How’s LR computed?

As the price continues to drop, the return gets better and better? Assuming the rent cost stays approximately the same.

I still don’t quite understand the difference between SFH and condo. Seems like $/sqrt wise condo is more expensive, which makes it worse as primary residence, but better as investment property?

[NotCranky]

I have that number in mind from some experiences 10 years back when I bought my second house and used the cash flow from the first on my loan application, and conversation with lenders and investors since. I was told it included vacancies, maintenance,advertisement ect. Perhaps it was because I was a rookie. I have been throwing that number out here on Pigginton’s and nobody has corrected it. Maybe things are different now? I would like to know.

[(former)FormerSanDiegan]

gn, Rustico –

Last time I did any refinancing for my rental prop (2005) the lender considered my income from the rental at 75% of the actual rent charged.

I remember it being this way as far back as the mid-to-late 1990’s as well. I am sure some lenders were more lax than this the last few years, however, the 75% figure seems to be the amount used by traditional lenders/underwriters.

My guess is that any lenders who assume greater than 75% will have either gone out of business or tightened up their standards by now.

[4plexowner]

I had numerous loans on multi-unit properties during the 1998-2005 timeframe

Lenders never gave me credit for more than 75% of the income from rent

[surveyor]

LR loan reduction

Loan Reduction is the amount of interest that you save by paying back a portion of the principal. So basically multiply the principal paid back in one year with the interest rate. Made an error in that post above, the LR should only be about $110. So the ROE above is actually 13%.
I usually set LR at 0 anyways. It’s so low.

Yes, the more price drops you see, the better it becomes as an investment. Rent will usually go up about 4% or 3% a year though so you usually have to run the numbers once a year to see how it’s doing.

Regarding the difference between an SFH and a condo, there are advantages to either properties. SFH usually appreciate better than condos (being the first to rise and the last to fall). SFH’s are also easier to sell. Condos usually appreciate last and fall first in prices. Condos are also harder to sell, because you are competing with every other condo owner next to you. Because appreciation is what most real estate investors are after, condos don’t do as good of a job appreciating than SFH’s.

It looks like you want to look into real estate investing. You should start reading up on it so that you can position yourself well into the next few years. I recommend Lisa Vander’s book “The Real Guide to Making Millions in Real Estate” but most real estate investor beginner books will do.

I definitely agree with SD Realtor where most of the seasoned investors have left California or at least stopped buying. I still see a lot of novice investors running around buying $600k homes because they thought it was a good rental property (yikes!). I really don’t think San Diego and parts of California will ever really cash flow from now on (but I reserve the right to be wrong).

From my research, North Carolina is actually a negative cash flow location and you will make most of your money from the high appreciation. The real estate cycle there is near the top if not at the top from my observations. Still, it is a lot easier to buy an investment property in North Carolina (where prices are around $200k to $300k) whereas California has comparable prices of $800k. North Carolina still has a decent amount of growth left in it.

So from what I’ve seen:

High appreciation but low to negative cash flow: North Carolina, South Carolina (I have a four-plex there), Georgia, Texas.

Avoid!: California, Nevada, Florida, New York, New Jersey, Arizona (these are the bubble areas).

Cash flow but low appreciation: Alabama, Tennessee, Missouri, Idaho and some parts of Texas.

I’ve been trying to buy some four plexes in Huntsville, Alabama for the past month now, but my realtor hasn’t been sending me any properties (he’s probably keeping the good ones to himself, dangit). The ROE’s I’m getting for area is running around 30%.

But as 4plexowner will tell you, owning out of state is a PITA…

(is it friday yet)…

[SD Realtor]

Good points Surveyor. Thank you for the correction on North Carolina, I should have been more clear in my post. Just curious to see if you have studied anything in Tenn at all as well. We have poked around a little bit but nothing in a serious manner.

The numbers that you strive for regarding your ROE just go to show what serious investment property owners shoot for. Alot of people that ask me about investment property always say that I am very negative about it. I try to correct them to say I am not negative about it, but that there is a right way to do it and a wrong way.

I have rentals but they are not for investment purposes, they are places I have lived in and just never sold. The one property I bought for a rental was also a standby for a relative. Had I ever thought of seriously trying to make money on rentals I would do it the way you are doing it which is alot of hard work. It seems like finding the robust market is the hardest part.

SD Realtor

[gn]

If a property goes to around 25% to 30% ROE, it is considered a good purchase (assuming optimal conditions!).

surveyor, thanks for the formula. Can you elaborate on what you mean by "optimal conditions" ?

[Author]

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