In yesterday’s post, in which I addressed why Texas is the place to put your real estate investment capital, Dave, a reader for some time, apparently, asked a couple questions. They were so good, especially the second one, I thought the answers deserved center stage. So, thanks Dave.
Here’re Dave’s questions, verbatim, with text before and after, edited out. You can still see his comment in its entirety by going to the link above.
Let’s assume one buys a $250,000 home in Austin. He puts down 20% and gets a 30 year loan at 4.62% for $200,000. He rents it out for $1375/month. He has plenty of cash stored away in case of an emergecny. Here is how my numbers would look:
mortgage=$1,025/month
insurance=$45/month
taxes=$100/month
maintenance=$100/month
property manager=$108/month (8% of 1 month’s rent)TOTAL=$1378
Basically, it would be a breakeven. So, what you are really saying is that it is perfectly OK to not cash flow. As long as one buys in the right location and has the right time frame, then the plan would still work out over the long run. Is that correct? Are my numbers somehwat close to being correct for buying a nice home in a good area in Texas?
Where do I begin?
I’ll take most of the blame for this one. You’re foundational assumption is inaccurate — the property of which I was speaking wasn’t a house. It was a duplex. The rent wouldn’t be $1,375/mo. It’d be anywhere in the range of $1,225-1,3550/mo per side. So, if you used a recent, real life example, it’d look something like this.
Paid $255,000 — rented $1,350/side — $2,600/mo — $31,200/yr, gross rent. Expenses would run in the neighborhood of $11-12,000. This would include everything. My clients only pay 5% management fee.
Let’s say the Net Operating Income (NOI) is around $19,500 or so. At 5% interest your monthly/yearly debt service, at 75% LTV, would be $1,026.67/12,320. You can readily see there is some decent cash flow there. Again, I take responsibility for you thinkin’ it was a house, and not a duplex.
But you ask a great question, Dave. Is break even OK? Well, yes, and no.
In today’s investment climate, I’d be far less inclined to advise clients to accept a break even property. On the other hand, the key question would have to be — What would the specific circumstances be? In past eras I’ve literally begged a few, select clients to purposefully buy multiple properties with a combined negative cash flow that’d make your head spin. But those were way different times than we have today — and that’s an understatement if there ever was one.
BawldGuy Axiom: The real estate investment strategies applied for a particular investor must be selected with an intimate knowledge of the economic climate, IRS rules/regs, and the general/specific investment context of the times. A Purposeful Plan using multiple strategies synergistically, is only effective when they’re all applied in the correct context. For instance, a strategy with appreciation as a crucial factor in today’s investment reality would be, um, ill advised. (Captain Obvious alert!)
Back to our regularly scheduled program.
Investors in those days could depreciate property twice as quickly. There were NO limits on how much depreciation they could apply to their ordinary (job) income. There were NO limits to how much they could make in ordinary income in order to make use of depreciation. Those two factors aren’t in play today — period.
Combine those facts with the reality of the cartoonish appreciation of that time. (Mid-late 1980s.) Back when I was tellin’ a very few select clients to purposefully acquire relatively large negative cash flows, their properties were goin’ up in value 8-15% a year, year after year. Even applying the bottom of that range for five years on a half million dollars of property — roughly $1.5-2 Million in today’s San Diego values — they’d see their property values balloon by nearly 50%. At 10% a year, their $500K in property would rise to about $805K, a 61% increase in five short years.
But that didn’t tell the real story, at least not from the investor’s point of view.
What I didn’t tell you earlier, is that in those cases my clients were easily able to buy properties with just 10% down payments! That means that in five years, heck, just three years, at 8% annual appreciation, their $50K beginning equity position was improved to roughly $180K! Put another way, their invested capital, (I’ll use $60K to account for acquisition closing costs.) was literally tripled in just three years.
Their negative cash flow? Completely eliminated in two very concrete ways.
1. Their income taxes were drastically reduced, in many cases by nearly 90%. In essence, they had merely traded income tax dollars for short term negative cash flow dollars. Quoting one of those clients, “Where do I sign up?!” 
2. In an inflationary economic environment, rents tend to float up with the rising prices at the grocery store. This tends to add velocity to the elimination of negative cash flow. Go figure. (See? Give Captain Obvious an inch, and he takes a mile.)
BawldGuy Takeaway: No real estate investment strategy can ever be implemented effectively sans the context of the current economic realties, IRS rules ‘n regs, and the investor’s specific financial status quo. Without knowing those factors in rich detail, you might as well blindfold yourself and throw darts at a list of investments, locations, and strategies.
Sadly, that’s almost what so many seem to be doing the last several years. Strategies don’t exist in a vacuum. Economic realities are ever changing. What was a great market in which to invest a decade ago, is now a graveyard for investment capital and retirement dreams.
Thanks again, Dave, for your kind words and excellent questions.
Call me with your questions! I need a fix, and I need it now. My number is 619 889-7100. Your other option is to click the Contact BawldGuy button up top, and write me. Have a good one.