Did I Just Fall In Love with Real Estate?

by JT McGee

My response to real estate as an asset class has always been “meh.” Perhaps it’s because it’s too predictable, not as much fun as equities, or maybe just because it seems old man-ish. You know – grey hair, blue pin stripe suit, and a gold watch at a country club type old man.

But recently, I’m having a bit of a change of heart.

Lingering Conflicts with Real Estate

My biggest complaint with real estate is that the market is slllloooooow. That is to say it is very difficult to find a property generating 10% returns that can be sold a few months or even years later at a price that implies a 6% return.

This happens all the time in the stock market. This is pretty much my investing strategy in a nutshell – buy a company at a high discount rate or free cash flow yield, sell when the market implies a low discount rate or free cash flow yield. In most cases, I’m looking for companies that can reliably generate free cash equal to three times the current rate for long-dated government securities. So, right now with 30-year Treasuries at 4%, I want companies that have a free cash flow of at least 12%.

In an ideal world, the market will come to its senses and price a stock at a free cash flow yield of 8% from 12%. My investment would then rise in value by 50% and I’d move on to the next.

Mo’ Cash Flow in Real Estate

Here’s an example of a deal available in my area. An all-brick duplex built in the 1960s is up for sale for $85,000. The house is in a very good area – a place where I would not hesitate to live for a minute. Both sides of the home are currently occupied, and renting for $550 each, or $1100 per month.

That implies a return of 15.5% per year. Granted, there are plenty of expenses, but assuming even one-third of the rent is dedicated to maintaining the property, the return is still an easy 10% per year. These are well built homes, so I don’t think there’s any real major work to be done. Also, the price and yield is consistent with other duplexes in the area, so this isn’t an odd-ball cheap-o property.

This is the kind of return that is very, very hard to find in large caps. I can find this kind of free cash flows in companies worth $200 million to $5 billion with regularity. However, the leverage is what really changes the whole ballgame.

Assuming 20% down, the mortgage principal is only $68,000. The monthly payment works out to $328 financed for 30 years at a 5% rate. Assuming crazy upfront costs of $3,000, we arrive at total initial out of pocket investment of $20,000.

Expected Returns

Returns are outrageous. If operating expenses are kept to 33% of rents, the property would generate $4,776 per year in free cash. That’s a cash on cash return on my $20,000 of 23.8%. This does not include any potential increases in the property value, growth in ownership equity, or increasing rents in excess of additional operating costs.

Now, let’s go really conservative and say 50% of rents are used up in operating costs. Free cash falls to $2664 annually, which is a cash on cash return of 13% per year. Again, this does not include any potential increase in the property value, growth in ownership equity, or increasing rents in excess of operating costs. Basically, I’m assuming a very terrible worst case scenario.

Real Estate Does Make Sense

Finally! Real estate as an asset class does look like it’s starting to make sense. Even though the total return from this particular property is fairly small on a dollars and cents basis, the returns on a percentage basis are quite large. The question is, then, is dealing with two tenants worth cash flow of $2600-$4800 annually, plus a free duplex after 30 years of renting?

{ 12 comments… read them below or add one }

Sam April 16, 2012 at 01:42

That’s a great cash on cash return!
The secret to make it worth your time is to obviously buy many such properties as $2,500-$3,500 a year is still not worth the hassle. But $25,000+ a year, then probably!

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JT McGee April 16, 2012 at 12:20

Heh, $25,000+ per year is 15-20 tenants, or 7-10 duplexes in year 1. That’s a big bite to chew and swallow, but the potential for compounding is definitely there.

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Jonathan April 16, 2012 at 10:41

JT, real estate has just been sitting there waiting for you to notice!

Are there more places like this at similar prices? If you can buy 5-10 of these then you’d be looking at some pleasant cash flow. A little bit of a market recovery in the next 10 years and you can cash one or two of them in and have a nice-sized down payment for something with better cash flow! And I’d say yes, it’s worth it despite two tenants…especially if you’re putting money aside to hire someone to do some of the dirty work.

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JT McGee April 16, 2012 at 12:19

There are literally piles of these spread around town. A quick look again at the listings on a single site shows 2 more duplexes in good, but not awesome areas with cap rates of 16-18% per year. A 3-plex yielding just under 23% is also up for sale. I’m not digging very hard, nor am I looking at areas in totally awful areas. And, actually, I’m skipping through every listing that isn’t a brick home (can’t stand aluminum siding, and it’s just another thing to clean/replace). These are all currently full with tenants, too.

If I were to get into one of these things, I’d do it with a goal of it being something I remember only because of the rent checks. I’d rather price in 50% of rents to all operating costs including maintenance just so I don’t have to deal with it. Total return goes down, but time is a much more limiting factor, in my view.

I just don’t see as much capital gains in investment property as I do in SFHs, but all things considered, the cash flow is WAAAAAAAY better.

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krantcents April 16, 2012 at 15:00

Real estate should be part of any porfolio. You have almost a perfect storm with home vales low and mortgage rtates low too, but you still need to be careful.

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JT McGee April 17, 2012 at 17:27

The price of money is pretty awesome – the availability can be a bit of a hangup, though. It seems that qualification requirements have really gone up in a way that limits somewhat the potential for pre-bubble style leverage.

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American Debt Project April 17, 2012 at 17:29

The numbers sound great and I think the 30-50% of rents is a conservative enough estimate. Quick question on this, would you be OK buying this place when you don’t own the property you live in? I don’t know if you do or don’t, I’m just wondering about what your idea on this is as a principle (don’t buy investment property before taking care of our own housing).

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JT McGee April 17, 2012 at 22:20

This is a very good question, and one which may justify a whole post. I’ve thought about this a lot, perhaps more than is reasonable to think that this is a good idea.

As far as principles, I don’t really care. Principles are principles, not life guiding references for how to manage your finances. I’ve written a lot of posts regarding my objections to personal finance principles such as “never finance depreciating assets” and others.

The beauty of investment property is that, for me, I’ll never have to make a long-term commitment to remain in the same place. By that, I mean that I won’t live in it, so it doesn’t really matter if I move elsewhere. There are plenty of people – parents or property management, in particular – who could quite easily take care of the day to day. Whereas a 30-year mortgage on a principal property is an essential wager that you will live in the same place for 30 years (or at least 5 years, the common breakeven point) an investment property is something quite easily left behind.

Also, I think there is plenty of rationale behind renting property, and then owning investment property. For example, you could quite easily turn properties in areas that you would prefer not to live in into cash flow positive assets that afford rents in areas in which you would like to rent. I separate the two into investments and lifestyle, so it’s really not that important to me.

I’m going to turn this into a post. Thanks for the idea. There’s a lot to think about and discuss here – perhaps far more than I ever realized.

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American Debt Project April 20, 2012 at 12:15

That is a great insight, and it actually helps me a lot. Where I live (and in close proximity to work) real estate is very expensive and few properties that make sense as income-producing assets. But in the next county over, there are some excellent values that would make very good rental properties. My hesitation has been buying the place and not living in it, because I would need to live in it for 6 months in order to have it not be viewed as an investment property (and thus requiring 30% down). I don’t want to put 30% down. So I’m hoping to acquire one of these properties as a first-time homebuyer and if I have to, I could live there for a year and just suffer a 60 to 90 minute commute.

I’m looking forward to the post. Glad I inspired it!

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Jonathan April 18, 2012 at 10:18

I’m closing on my 3rd rental property next week but we still rent our residence. I agree with JT that it’s a lifestyle issue vs. an investing issue. We’ve got a pretty sweet setup renting, and it would definitely be much more expensive to own. At this stage in our lives it makes far more sense for us to pour cash into income-producing assets so that in 3-5 years when we outgrow our current place we’ll have lots of investment income rather than have a bunch of costs sunk into our primary residence.

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American Debt Project April 20, 2012 at 12:18

Jonathan, do you have to put 30% down for each rental? And you are right, not having sunk costs in a primary residence you plan to outgrow in 5 years is a very smart idea. You are looking much more long term than I am used to as I’ve often got hung up on my immediate lifestyle choices. Moving away from that is huge.

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Jonathan April 20, 2012 at 12:43

We put 20% down. Before buying the first we considered options for buying as a primary residence, but since the houses are 80 miles from home and jobs, it didn’t make any sense. Aside from the questionable ethics of such a decision.

Have a plan! Or at least have goals! My wife and I love to “dream and scheme.” We go on long walks through our neighborhood and talk about our short and long term goals and what we are doing and should do to reach them, and what we’d do if things work out better than we hope they do, etc. It’s great because we feel like we’re following a pre-determined course and making great strides toward our envisioned future.

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