There’s an investment class I’ve deliberately not spent much time discussing yet: real estate. In light of Brexit and some increased volatility in the stock markets, I think the time is right to start talking real estate.
I don’t mean your home. I don’t mean that piece of swampland Aunt Bessie left you in Central Florida either. I mean rental properties.
Ask some people you know if they’ve ever looked into the rental property business. You might be surprised at how many folks have already taken the plunge. I know the more folks I’ve asked, the more surprised I’ve been at how many people and who owns one or rental properties. I think there are a couple of reasons for this:
- Almost passive income
- Sustainable side hustle
- Return on Invested Capital
Almost Passive Income
Most folks work for their paychecks. We trade our priceless time for an hourly wage. Passive income lets us change the game by avoiding this traditional approach to creating income. I first started reading about passive income as a concept in Rich Dad, Poor Dad (Affiliate link). To this day, it remains one of my all-time favorite personal finance books. Passive income has the ability to help each of us achieve our financial freedom earlier. Passive income lets us get to that “Freedom Uttained” point faster.
Think about it like this: let’s say I have an annual salary of $100k. And, I spend about 2000 hours a year to get that salary. That works out to $50/hr. Not too bad, right!?
I should even tolerate grey cubicle hell for a while at $50/hr. But, I can’t. I want more. And, I suspect most other people do too. I’ll dive into the details of my experiences with rental property in future posts. But, for now, let’s say I net about $500 a month from a rental property (net = rent – all expenses/reserve contributions). And, I spend an additional 5 hours a month managing my rental property. That sounds pretty doable. Apparently, Americans spent more than 5 hours a day watching TV in 2015 according to the Bureau of Labor Statistics. You know where I’m going with this: the simple math says, I just made $100/hr. Each month (on average). Until I sell the property.
Turn off the TV and go make your own life better!!!
And that is the beauty of the rental property business. You still have to trade some time for cash. But what you get in return is a seedling. Your first money tree sprout that may eventually blossom into the life you want to live.
Sustainable Side Hustle
Let’s say my wife and I spent almost 500 hours researching, screening, visiting, negotiating, reviewing contracts, rehabbing, and finally renting out our first rental property. (It was our first, and I’m pretty risk averse!) Now we spend about 5 hrs a month managing it. Some months it’s more. Some months it’s less. But, we manage it outside of our day jobs. And, the checks keep coming in. To be sure, we don’t plan for 100% occupancy. In fact, we’re coming up on our next lease renewal, and we will likely have some down-time while we make a couple of improvements and complete some maintenance items. But overall, we’ve found a way to take some of our surplus cash flow and turn it into gold. Now, someone else pays our mortgage on the rental property. Their rent covers the routine maintenance costs and fills out a savings account for bigger items. All we have to do is wait…
Return on Invested Capital
And that brings us to the actual topic I wanted to dive into. You see, we didn’t pay cash for the full value of our rental property. We have a mortgage. So, let’s do a little math with simplified numbers:
We’ll buy a $100,000 property at market value. In the first situation, we’ll put down 25% because this is an investment property, and the bank wants a little more skin in the game (or they charge a higher interest rate). The bank offers us a 4.5% rate resulting in ~$500 per month in principal and interest payments.
In the second situation, we’ll buy the same property with a suitcase full of cash.
Is this the best way to buy a rental property?
Our rent is the same for the property: $1500/mo. Our costs for taxes, maintenance allocations, utilities, etc. are the same regardless of how we bought the property. Again, keeping things simple, we’ll estimate that at $500/mo. Also, for the sake of simplicity, I’m ignoring closing costs,any renovations, and a few other items that are roughly comparable regardless of how the property was financed.
Is it better to buy with leverage or all cash?With
With our loan, we put down $25,000. Each year, we would bring in a theoretical $6000 of profit for this property. That’s a whopping (hypothetical) 24% return on the investment we made. Compare that to buying the property with $100,000 in cash. We bring in $12,000 profit. Even though the total dollar amount is higher, we’re only making 12% on our $100,000 investment. Not too shabby, but now we’re out of cash.
In theory, we could use the $75,000 we didn’t spend in the first scenario to buy three more properties! Using leverage, our new situation looks like this:
Living dangerously? Or, spreading the risk?
Now, we’re making that same 24% on our money. And, we’re clearing $2000 a month. Freedom Uttained point, here we come! Of course, we had to take out $300,000 in loans to get there. There’s now a higher chance that we cannot pay all 4 of our mortgages if all our properties are vacant. But, what are the chances that all four properties are vacant at the same time? Probably smaller than the chance that the single one is vacant in the case of our all cash purchase! We just spread out our risk, boosted our returns, and launched ourselves on the path to real estate mogul.
In my mind, this illustrates why real estate is such a neat asset class. You can buy a full property with 20-25% down. Doing that with stocks seems way riskier. If you hold the property long enough, your tenants completely pay off your mortgage for you. Now, your net returns go through the roof. Leverage lets us either get into the game a lot earlier or use the cash we didn’t deploy by borrowing to further increase our holdings. Either way, what we do with our limited resources matters. And Return on Invested Capital is one way of looking at investments to help us decide where to allocate our limited resources and reach financial freedom that much sooner.