Several folks have asked that I describe the approach I use for financial analysis on rentals. I am neither a lawyer nor an accountant, so take this all with a grain of salt. Be warned … this is a long post … started as a crisp summary and evolved into a stream-of-consciousness, which many of you will find tedious.
Background: I have a ‘real’ full time job, unrelated to the construction business, from which I hope to retire in about 3 years. I’m buying rental property now (4 buildings so far) so I can hit the ground running with a job & income stream.
Game Plan: Buy property that meets several criteria: 1. Break-even or better (whatever that means – see analysis) – note that I try to buy without realtor commissions, directly from owner ; 2. High upside potential – property that is ‘worthy’ of adding value through my labor; 3. Low risk – for me, that means staying close to home, in an area I understand well, and most importantly, only looking at properties that are walking distance to the commuter rail station (where demand is constant).
Facts and figures:
|
|
Property A (2 family) |
Property B (2 family) |
Notes |
|
Purchase Price (including closing costs and improvements necessary for occupancy) |
$487,000 |
$283,000 |
|
|
First Mortgage (3/1 ARM) – Amount / Rate |
$322,700 / 3.375% |
$211,600 / 4.0% |
Buying rental properties with 3/1 ARMs is unusual – it IS risky, but I believe that if interest rates go up, rents will go up too, so the risk is minimized. |
|
Principal (monthly) |
$540 |
$313 |
Principal and interest amounts vary slightly month to month, constantly moving in a direction that improves results. |
|
Interest (monthly) |
$886 |
$697 |
|
|
Second Mortgage (Interest only) – Amount / Rate |
$60,000 / 5.25% |
$13,000 / 6.75% |
|
|
Interest (monthly) |
$262 |
$73 |
|
|
Second Mortgage on Primary Residence (Interest only) – Amount / Rate |
$104,300 / 4.5% |
$58,400 / 4.5% |
Even if you put cash down to buy a property, if you have any debt anywhere else, you should count it in your analysis – otherwise, you could have used the cash to pay off this loan. I use loans against my primary residence because it is tax deductible (up to $200,000, I think) |
|
Interest (monthly) |
$391 |
$219 |
|
|
Property Tax (monthly) |
$525 |
$347 |
|
|
Insurance (approx) – (monthly) |
$90 |
$60 |
I have all of my properties (plus an umbrella liability policy) on one policy, so I don’t have an exact breakout for each, but this is pretty close. Note that I own these directly and have not set up an LLC. |
|
Maintenance (est) (monthly) |
$100 |
$100 |
This amount seems reasonable so far – in fact, by doing everything myself, I’ve stayed well under this amount so far. |
|
Depreciation (building only) (monthly) |
$660 |
$370 |
Purchase price minus estimated land value, divided by 30. |
|
Rental Income (monthly) |
$2,750 |
$1,800 |
There is significant upside available here, as soon as I have time to improve the properties. |
|
Cash Flow Analysis * |
($44) |
($9) |
Income minus all monthly expenses EXCEPT depreciation |
|
P&L Analysis * |
($164) |
($66) |
Income minus all monthly expenses EXCEPT principal payment |
* Taxes are not considered in this analysis. The amount of interest paid on the line of credit on my principle residence is tax deductible – using a 40% rate for federal and state combined, that’s a benefit of 0.4 x $391 for property A, and 0.4 x times $219 for property B, which means the cash flow and P&L both effectively improve for A&B by $156 and $88, respectively.
Cash Flow Analysis:
Taking taxes into account, Property A has a positive cash flow ($156-$44= $112), as does Property B ($88-$9=$79). Also, note that a significant portion of the monthly cash outflow is for principal re-payment, which can be considered a re-payment to yourself (I think of it as forced savings), so by my way of thinking (not to be confused with an official accountant’s view), I have a positive monthly cash flow of $112+$540=$652 on property A and $79+$313=$392 on property B.
Profit & Loss Analysis:
Again, after accounting for the tax advantage of using a loan on my primary residence to finance part of this, Property A shows a slight loss (164-156=$8) and property B shows a slight profit ($88-$66=$22). This is perfect for my current situation, since I don’t want to show any taxable income.
ROI (Return on Investment):
Since I’ve put zero down, in a strict accounting sense, any positive income is an infinite ROI. The way I prefer to think about this is to compare market appreciation on the properties to the depreciation. I think depreciation is more than a financial concept – it is a real event, that accounts for things above and beyond the routine monthly maintenance – things like new roofs, water heaters, etc., which are inevitable. Using round numbers, if half the value of the property is land and half is building, then depreciation is 1.67% of the purchase price per year (1/30 of 50%). So as long as market value increase by this much or more every year, my capital investment is growing in value. While you obviously can’t predict the market, you can mitigate the risk through sweat equity, improving the properties enough to make sure they always improve in value.
Final Kicker:
You are allowed to realize up to $500,000 (per couple) in capital gains every two years on the sale of your primary residence. You have to have a spouse who is a good sport to pull this off: we intend to move into a couple of these houses (one at a time, obviously), stay 2 years, then sell, realizing tax-free capital gains. Details are not worked out, but we’re pretty serious about this – since all the properties are in a small geopgraphic area and our kids are up & out, this should have minimal disruption on our lives. This one certainly isn’t for everyone!
I look forward to your critical feedback! Bill.
Replies
A couple of things to note.
The tax benifit that you have on the loan on your house is only "affective" as long has you have high income. It might not be as much benifit after you retire.
While you can get an exclusion on the capital gains on a principle residence after 2 years there are you need to watch out for a couple of things.
1. You will still have to pay 25% recapture taxes on that the amount that was depreciated.
2. I would go over this with a good tax person before finalizing your plans. I have not had to research this. But your cost basis might be fair market value when you convert it from investment property to personal. If that is the case then you would have convential captial gains which is still good at 15% (after asjustments for recaputuring the depreciation). And the amount that was excluded would only be the market value increase in those 2 years. However, you could help that if appropriate to do alot of upgrades or improvements that would covert personal labor to capital gains.
Bill - Thanks for the feedback.
You're right about the tax 'advantage' changing as my income decreases at retirement - I expect that by then, these will still be 'positive', even without the tax break.
On the capital gains issues, I'll certainly be fully educated before I subject my wife to a move!
Bill.
You are allowed to realize up to $500,000 (per couple) in capital gains every two years on the sale of your primary residence. You have to have a spouse who is a good sport to pull this off: we intend to move into a couple of these houses (one at a time, obviously), stay 2 years, then sell, realizing tax-free capital gains.
Bill-
You are correct that you can move into rental and eventually take the capital gain exclusion. But you stated that they were two families. The exclusion only applies to the residence. Are you going to kick out both rentals and live in the whole thing?
You get out of life what you put into it......minus taxes.
Marv
Yes - In one case, it's a 2 family that we will convert to single family. Another one is a single family that we will convert to 2 family. Another is a single family that we will rent for while, then move into. This is all in theory, of course. This aspect of the plan changes constantly, but is not really a crucial element of the overall plan.
Bill.
Observation: your allowance for insurance and maint. seem to be too low.
You seem to be relying on the appreciation too heavily and you are not allowing for recapture of the depreciation in your tax equation. The depreciation you took while it was a rental MAY be taxable when you turn it into your residence. Check with your tax preparer.
Seems like everything would have to work just exactly right for you to really come out ahead on this.
To me RE is a long term investment. I could be wrong.
"I will never surrender or retreat. " Col. Wm. B. Travis, The Alamo, Feb. 1835
Intrepid: The insurance is what it is, within a few bucks. Time will tell if my maintenance expense of $100 per month is understated - so far, it's held up ok.
I agree this is a long term play, and the margins aren't great right now. Over time, though, the amount I pay towards principal increases and interest decreases, and rents go up. Of course, with variable rates, I am also exposed to risk.
Bill.
I think you have it well thought our and realize the risks involved. If you are comfortable with them then that is all that matters. It is nice to see a new investor think about the program they are using early in the game and not after 10 years.
I personally would not be comfortable with the way your program is layed out. I don't view tax benefits as cash flow because so many other factors regulate that such as your income level and amount of personal tax liability.
I also don't like property that is that close on cash flow simply because one economic downturn 90 days after your retirement and you are swimming in red ink. I also have a policy of never planning on what a property can do but what will it do now is the numbers I use for setting up my program. I feel the tax advantages (which are great for people with dual or large incomes) and rent increases are a long term advantage.
My wife and I have bought, rehabbed and sold our home 3 times and used the tax benefit you describe. Get an accountant now so you have someone to call and check with so you know what you are dealing with. A good accountant will save you back what you pay in terms of strategy.
I am very conservative in my real estate business. Consequently I can brag about never having lost money at it and always turned a property. But with that low risk I can look back and see a few times I could have used your strategy and come out well. So again as long as you are comfortable that is what counts. DanT
Dan T and I have been doing it for a long time and I have to kinda agree with him but I feel more cynical.
Tax benifits is a perc and not to be added as support.
I never ever figgure an increase in any thing . I count on low figgures. My plan supports even recession. Fuel oil scares me for the future. If I cant buy it cheap enough to make it , I dont buy it. No thinking about it , I walk. I bottom line secret is in the "buy". Thats where the future is made, not expectations.
Your figgures are off on maintence support for the total price you are paying. You are in a high dollar area, why is this figgured cheap? You not counting your labor?
Im not seeing enough cushion for non rents. What is the average in your area for loss rents? Nationally its figgured at 80/20, but thats general.
I think you are gambling .
Tim Mooney
I have to agree with you... on this and on all things you make your money when ur buy'n... I like to be Idiot Proof... I'm never in a hurry to find something to buy but I'll but anything right now if it's a deal... period...
I try to only have commerical space... I happen to like strip shopping centers and small office buildings... for a few reasons... people are in em far fewer hours of the day... you are dealing with people who understand RENT is a cost of doing business... In my state I take a leasehold on whatever is in or on the property... I can change locks the day the rent is late if I want and i'm not putting someones kids out in the cold... I can charge a CAM fee on top of the rent... I can get 5 to 15 year leases... I can pass on all increases in taxes, insurance ect... I only fix roofs & parking lots in 90% of em... if anything else breaks or goes out they are required to fix it... I can name the buildings and shopping centers after my kids...
besides banks like em, 20 rents from one property are better than 20 properties with 20 renters
pony
Those are very compelling reasons. Maybe I oughta stop looking at run-down houses...
been doing this since the 70's,and i gotta tell you if i owned something worth 487,000 and was renting it for 2,750 i'd puke. before i ever walk in a door if it won't rent for 1% per month to value [1.5% for commercial] i just keep driving. but i live here in the midwest and it is beyond my thoughts of owning a 1/2 mil. house and renting it out. here with 500,000 i could buy 5 nice 1900 sf ranches with basements that will rent in the area of 1200 each [6k per month] and i would be a whole lot more diversified than having all my eggs in one house. i have to agree with other post about not counting your chickens before they hatch. i've seen some of my stuff go down so far i couldn't of sold and paid off the 70% to loan mortgages [ back in the 80's with regan at the wheel]. on the flip side they were so easy to rent back then because nobody was buying at 12-15% intrest.anyway now that i've been such a pessimist, the one thing i've learned over the years is, if i liked the deal,i wasn't going to listen to a bunch of of guys who said i was nuts.even though a few times they were right. do try and postion yourself so if things go south that you can hang onto your home.and i'd do that by improving the propertys and apperciation,then refinance to get the second off your house. larry
hand me the chainsaw, i need to trim the casing just a hair.
>>........nobody was buying at 12-15%<<<<
The thing I remember about those days, at least at the begining, was that people would buy almost anything at almost any price today because tomorrow the interest rate would be up another .25-.50%.
It was amazing. And lot's of people thought they were getting a bargain at owner financing rates of 10-12% when the owner who was financing had already jacked the price.
They were counting on appreciation to make up for the negative cash flow.
"I will never surrender or retreat. " Col. Wm. B. Travis, The Alamo, Feb. 1835
Edited 12/23/2004 1:26 am ET by intrepid_cat
i'm like you at the beginning we had just come out of 10 yrs apperciation and owner carrys were hot,like you said if they would carry at 10% price wasn't a consideration. the worse i got into was signing a variable on a pc. of comm. property. first year was 13.5 with a 6% cap. i remember the loan officer telling me what the payment was at 19.5, i laughed and said i'd never see it ,because i would of done let them repo by then! the look on her face-priceless larryhand me the chainsaw, i need to trim the casing just a hair.