Our article from September 29th entitled Choosing The Right Real Estate Investment Model walked you through the various ways to earn and build wealth through real estate. It’s very helpful to evaluate your own PARTS (Personal goals, Available time & resources, Risk tolerance, Time horizon and Skill set) to help guide you to what is the best fit for you and your current situation. Based on my PARTS evaluation, I have chosen the “Buy & Hold” model.
It is a basketball coach’s dream to have 5 ultra talented players (All Stars) on his or her team that all work together cohesively. This is approaching basketball nirvana. With the buy and hold model, you have no less than 5 extremely compelling forces that parallel this. The POWER of the buy and hold model, if used correctly over time and with smart leverage, should not be underestimated.
But… “Buy & Hold” Is A Misnomer
Using the term “buy” in the case of real estate investing is actually incorrect phrasing. When you buy something, it implies that you acquire the item by trading money for it. You use it and then it is gone. For example, you go to the gas station to buy a gallon of gas, you drive and then it’s gone and so is the money. When you acquire real estate with the intention of holding it, it is more like you are “moving” your money from where it is today into the home. The home does not get consumred and will most likely retain its value if managed appropriately. So therefore, your money is still there in your new home. It is not gone and you are not “spending” it. In fact, if done correctly the money will actually grow into more money because homes tend to appreciate in value (more on that later)
So Who Are Our 5 All-Stars?
1. Your All Star Point Guard: Cash Flow
Cash flow is simply the monthly amount of money left over from your gross rent after deducting expenses (mortgage, property taxes, insurance, property management fees, hoa fees, other). Many investors (including myself) treat this as the leading benefit and will only invest in properties that show clear visibility to ongoing monthly cash flow.
Basic Example* – Invest in a property that costs $150,000 with a monthly rent of $1,325
Monthly Costs: $1,002
- Mortgage = $662 (20% down @ 5.25%, 30 year fixed)
- Taxes = $150
- Insurance = $84
- Management Fee: $106
- HOA: $0
Monthly Revenue: $1,325
- Rent: $1,325
Revenue – Costs = $323 of Monthly Cash Flow
*Note – Assumes no maintenance costs or vacancy
2. Your All Star Shooting Guard – Appreciation
Over the long term, assuming properties are maintained and are located in a favorable area they most likely will increase in value. While home prices are certainly based on local market conditions, the Case-Shiller national home price index (see below) has increased by over 200% between 1987 to 2019. Of course there were periods of times when homes lost value, but over the long term, the data is compelling. There are no guarantees, but the $150,000 home should be worth more in 15 years. What will it be worth in 30 years when it’s paid off? The more it appreciates, the more your net worth builds. As appreciation and equity grows, you will have the option to tap into your equity through various refinancing options.
3. Your All-Star Wing Man: Mortgage Principal Pay Down
How would you like it if someone else paid your bills for you? In our cash flow example from above, if the mortgage on your rental property is $662, your 1st payment will consist of $137 in principal and $525 in interest. Based on this mortgage transaction, in month 1, the equity in your home (and your net worth) improve by $137. Not only does this happen every single month, but since the amount of principal that is paid increases every month (based on the loans amortization schedule) the $137 is the lowest amount of equity/monthly net worth that you will earn while owning this property with the original mortgage. In fact, 10 years from your 1st payment, the amount of principal paydown will be $231.33 and it will continue to increase every month thereafter. At an average of $231.33 over 20 years, the principal paydown is $55,519.20 and remember, who is paying down the principal? Not you, but your tenant. The longer you hold the property, the more the rent is not only providing you cash flow, but also building your net worth. Believe it or not, I enjoy getting the bill (mortgage statements) on my rental properties. The 1st thing I look at is how much my principal was paid down (net worth increased). Image.. being happy to receive a bill! I can’t think of any other circumstances, other than owning rental property where this would be the case.
4. Your All Star Power Forward – Tax Sheltered Income
Depreciation is your friend. The $323 of monthly cash flow referenced above has a silent but powerful component to it. The government treats homes, even though in most cases they appreciate, as depreciating assets. If you ever wanted to have your cake and eat it to, here is your chance. Everyone’s tax situation is different, and please check with your CPA on how owning rentals affects you, but the tax code allows property owners to depreciate a rental home over 27.5 years. The benefit of this is that during this time period you have “an expense which requires no payment”. Imagine if all of our expenses didn’t require us to actually pay! In our example, if your tax accountant calculates that you can depreciate your rental home by $320 per month, then you only need to pay taxes on $3.00 of income. That’s Huge! So your $323 of gross real estate cash flow is like (depending upon your tax bracket) earning over $500 of W-2 income since your take home pay on gross W-2 income is heavily taxed. Not only do you have an All Star Power Forward playing for you today but assuming you hold the property, you will have him working for you every single month for the next 27.5 years Note: There are tax ramifications of depreciation (depreciation recapture) for when/if you decide to sell your rental home (why would you?). However given the current tax laws, in most cases, these taxes can be deferred or legally avoided through a 1031 Exchanges and other strategies.
5. Your All Start Center: Inflation
Most people think of inflation in a negative context. Inflation = prices increasing. Acquire and hold real estate investors have a different perspective. In our example above the $150,000 home financed over 30 years has a payment of $662. Assuming the property is not re-financed, the payment will be $662 in 2 years and it will be $662 in 20 years. Think about this… Looking at it retrospectively and based on the historical rate of inflation, 20 years ago the $662 would have been worth $423.49. So assuming similar rates of inflation going forward and considering the purchasing power of your money, YOUR PAYMENT WILL “GO DOWN” IN SIMILAR PROPORTION. Although the absolute dollar number of your payment stays the same, the value of the money going out is not as high. Furthermore when inflation occurs what happens to the value of your rental home? It increases. Still more, what happens to rents in an inflationary environment? They increase and your all star center not only made your all star shooting guard (appreciation) more productive, but your all star point guard (cash flow) more productive as well. The greatest players make those around them better.
But Who Are We Playing Against?
Your all stars don’t play in a vacuum. There is resistance. Who are the toughest defenders out there trying to stop us? At 1st glance, you might think that a downturn in the housing market is the biggest risk or challenge to our model. But, if you have a long term time horizon, this is not the case. When I acquired my 1st rental property in 2004 in Colorado, it had lost about 16% in value by 2008. While this certainly didn’t look good on paper or feel good, it really didn’t matter because I had no plans to sell the property. In fact, rents increased during this time, so cash flow improved. The biggest risks and challenges to this model are a decline in the rental market, vacancy and maintenance.
According to the U.S Bureau of Labor Statistics, rents have increased 78.4% since the year 2000. While there is no guarantee that rents will not decrease for a prolonged period of time, history tells us that it would be a big anomaly if this were to occur. Even in a down economy, people still need a place to live. In a down economy, home ownership can be more challenging, implying that rentership will stay strong.
The 2 biggest factors to pay attention to as acquire and hold investors are vacancy and maintenance. Vacancy (when there is no rent coming in) temporarily neutralizes your point guard (cash flow), your wingman (mortgage paydown) and your power forward (tax sheltered income). Maintenance also temporarily neutralizes your point guard. The good news is you most likely still have 2 other All Stars (Appreciation/Inflation) playing for you when these things happen. So how do you combat vacancy and maintenance? Answer: you work with the right team.
A strong property manager is very well dialed in to the local rental market and therefore knows what to set the rental rate at to keep the home tenanted. A very strong property manager knows how to identify renters who will have a pride of rentership which reduces risk of unnecessary maintenance. A still stronger property manager knows how to identify and attract tenants who will be more likely to stay for extended periods of time (years). Vacancy and maintenance can never be stopped (you should budget in a percentage of rent and hold reserves for when they occur) but if you partner with the right people, vacancy and maintenance can be contained.
Individually, each of our 5 all stars represent fantastic benefits that make acquire and hold real estate investing very attractive. When all 5 are combined together and working synergistically over time, they create an incredibly valuable vehicle for wealth building. The POWER of this vehicle should not be underestimated.