Cash Flow and Equity Build-up

Many years ago, Las Vegas hotels would entice customers with inexpensive rooms, meals and entertainment so they would gamble. It may have worked initially but if you’ve been to Las Vegas recently, the bargains are gone. Hotels expect each division to be a profit center on its own. As a consumer, I might not like the changes but as an investor, I’d have to be pleased with increased profitability.

Years ago, real estate investors used to accept negative cash flow buoyed by tax incentives in hopes of making a big payday due to appreciation when they sold it. Today’s investors are focusing on tangible, current results like cash flow and equity build-up.

Cash flow is the amount of money you have left over after collecting the rent and paying the expenses. Since rents have gone up considerably due to supply and demand in the last few years and mortgage rates are at near record lows, income is up and expenses are down, making the cash flows attractive.

If the cash flow is sufficient, you could have a good investment even if the value of the property never increased. Cash on Cash doesn’t consider appreciation and measures the cash flow before tax advantages by the initial investment. A rental with $3,170 CFBT divided by an initial investment of $29,000 would generate a 10.93% Cash on Cash rate of return.

Low down payments on investor properties are also a thing of the past. Non-owner occupied mortgage money is available but the investor should expect to put down 25-30%. An advantage of having a smaller mortgage is a lower payment.

Most mortgages are amortized loans with both principal and interest due with each payment. The forced savings of the principal contribution builds equity in the property and can be considered a part of the rate of return.

A $100,000 mortgage at 4.5% for 30 years would have $1,613.29 applied to principal in the first year. Divide that by the same $29,000 initial investment and the amortization would generate another 6%.

Without factoring in appreciation or tax advantages, this rental example generates much more than most alternative investments. There certainly are many different aspects that affect the risk and return on rental investments. If you haven’t scrutinized single-family rental opportunities in a while, you should look again.

 

Find a Better Return

A certificate of deposit will generate a cash flow based on the interest rate that it pays which is the only way it generates a return for the investor.

An investment in a stock that doesn’t pay dividends, would need to be worth more than you paid for it to earn a profit. On the other hand, a stock that paid dividends could make the investor a profit even if it sold for the same price that he paid for it.

Investors can profit four different ways with an investment in rental real estate.

1. Cash flows that result from having a surplus after collecting the rent and paying the expenses.

2. Equity build-up results from a portion of each monthly payment reducing the unpaid balance.

3. Tax benefits can result from the depreciation allowed on the property and the preferential long-term capital gains tax rate.

4. Appreciation benefits the investor when the value of the property increases.

The most conservative investors in real estate make decisions to purchase a rental property based on its ability to generate a cash flow and reduce the mortgage through normal amortization. If the property can offer an acceptable rate of return compared to other available investments, the tax benefits and possible appreciation become an added bonus.

With increased rents and low mortgage rates for investors, rental property can offer significantly higher returns than many of the available alternatives. Contact me for more information- Aembry@remaxlubbock.com; you may be amazed about what is available in the market.

 

Who’s Paying Your Mortgage?

As a homeowner, you obviously pay for your mortgage but as an investor, your tenant does. Equity build-up is a significant benefit of mortgaged rental property. As the investor collects rent and pays expenses, the principal amount of the loan is reduced which increases the equity in the property. Over time, the tenant pays for the property to the benefit of the investor.

Equity build-up occurs with normal amortization as the loan is paid down. It can be accelerated by making additional contributions to the principal each month along with the normal payment. Some investors consider this a good use of the cash flows because interest rates on savings accounts and certificates of deposits are much lower than their mortgage rate.

In the example below, is a hypothetical rental with a purchase price of $125,000 with 80% loan-to-value mortgage at 4.5% for 30 years compared to a 3.5% for 15 years. The acquisition costs were estimated at $3,000, the monthly rent is estimated at $1,250 and $4,800 for operating expenses.

Notice that both properties have a positive cash flow before tax. The cash on cash return is the revenue less expenses including debt service divided by the initial investment to acquire the property. The 15 year mortgage will obviously have a smaller cash flow and lower cash on cash but the equity build-up is significantly higher.

If the goal of the investor is to pay off the property to provide the highest possible cash flow at a later date, a shorter term mortgage with a lower interest rate will help them achieve that. A simple definition of an investment is to put away today so you’ll have more tomorrow. Sacrificing cash flow now, during an investor’s earning years, is a reasonable expectation to provide more cash flow in the future when it might be needed more.

Contact me if you’d like to explore rental property opportunities.

 

Where Is It Invested?

You’ve saved for a rainy day or retirement. Congratulations but don’t get too comfortable yet; where is it invested? It’s estimated that over 25% of Americans have their long-term savings in cash instead of investments like stocks, bonds or real estate.

The memories of the financial crisis of 2008 are recent enough to understand why some people may want to avoid the stock market and real estate. Even though Wall Street and housing have rebounded considerably, uncertain investors are sitting on their cash. However, trying to avoid a bad decision can have serious costs too.

If your money is not earning at least at the current inflation rate, you’re losing the purchasing power of your dollars. Bankrate.com estimates the average money-market deposit yields 0.11% and the average five-year certificate of deposit currently yields 0.78%.

Rents are continuing to rise and there is a shortage of good, affordable housing. Single family homes have a significant advantage over many other types of investments. They have high loan-to-value mortgages available at fixed interest rates for long-terms on appreciating assets with distinct tax advantages.

The cash flows are considered to be one of the most attractive features of rental properties. Some investors think of it as a growth stock that pays substantial dividends. In the example shown below, a $125,000 rental with an 80% loan-to-value mortgage at 5% that rents for $1,250 per month, has a positive cash flow before taxes of $3,000 a year.

The rate of return on rental property can be substantially higher than other investments while allowing the investor control that isn’t available in alternatives.

 

If I’d Known…

We’ve probably all said or at least thought “if I knew then, what I know now, I would have done things differently.” We should have stayed in school longer. We should have listened to our parents. We should have bought Apple stock in 2002 for $8.50 that sells for $400 today. Or we could have bought gold in 2000 for under $300 for a four-fold profit today.

Years from now, if we look back at 2012, we may say that it was the best buyer’s market ever. Even now, in 2013, it’s apparent that both housing and mortgage prices are going up and they may never return to the record low levels.

The housing affordability index, which is considered to be good at 100, had increased to over 200 this past December, January and February. Shrinking inventories and rising prices in most markets have caused the index to fall to 172.7 for May 2013.

This market applies equally to acquiring a home to live in or a home to use as a rental. It is estimated that about 30% of the property purchased last year was done by investors. It is understandable because the positive cash flows far exceed most other investment alternatives.

Homeowners moving up in a rising market may sell their home for more by waiting but it will also cost them more for a new house. Typically, a person buys a 50% larger home when they move up. If they wait for prices to go up 10% on the $150,000 home they’re selling, they’ll realize $15,000 more but will pay $22,500 more for the new home purchase. They’ll actually net $7,500 less by waiting for prices to go up and may have to pay a higher mortgage rate too.

The question homebuyers and investors alike are faced with today is whether they will be saying years from now that they seized or missed an opportunity of a lifetime.

 

Let Your Tenants Send Your Kids to College

Most people have lots of things to save for but not always enough discretionary income after the family essentials have been met.

A relatively small investment in a rental home can control a good home that will easily rent, generate positive cash flows and pay for itself. The borrowed funds create leverage that earn a return on the total value of the home and not just the amount of cash you have invested.

The strategy is simple. Find a slightly below average priced home that will rent well. It will appeal to a larger group of people while it’s rented and when it’s ready to be sold.

Rent the home and maintain its condition over the years. As the loan amortizes and the value increases, the equity will grow. When your student is ready to start college, you’ll actually have several options.

You can sell the property; pay the tax on the gain at the reduced capital gains rate and fund the education. Another option would be to refinance and take the proceeds to pay for the tuition. This would allow you to continue to own the asset but would free your equity and under current tax laws is a non-taxable event.

Regardless of whether you’re trying to plan for your children’s education or your own retirement, rental property offers many solid investment opportunities. Contact me if you want more information.

 

Contributing Factors

Rental properties have four primary factors that contribute to a return on investment. Based on market conditions and investor strategies, the individual motivating factor can change for property owners.

There was a time when the benefit of tax savings to offset income from other sources was considered important to some investors. However, in today’s environment, they are more likely valued as incidental benefits.

Some investors expect appreciation to deliver the satisfactory results which can be reasonable over time if a reliable appreciation rate is used. Savvy investors today are using conservative estimates for long-term holding periods.

Leverage occurs when borrowed funds are used to control a larger asset. Positive leverage can actually increase the yield on an investment.

The fourth component that contributes to a property’s yield is the cash flow. When the rents are greater than the expenses of operating the property and servicing the debt, there is a positive cash flow. A property with a good cash flow doesn’t have to go up in value to justify the investment.

The combination of lower prices, incredibly low mortgage rates and rising rents are attracting investors to rental properties that include single-family homes in predominantly owner-occupied neighborhoods.

Even if you were to ignore the benefits of tax savings, potential appreciation and leverage, the attractive cash flows make rental property a very smart investment alternative. If you’re curious, contact me for more information.

 

Single-Family Homes for Rentals

Single-family homes used for rental property have distinct advantages over other types of investments.

An investor can borrow 75-80% at fixed interest rates on appreciating assets with definite tax advantages and reasonable control. The financing alone is attractive compared to some investments that require 50% cash and have floating rates at prime plus for one or two years.

Home prices have adjusted 30-40% around the country, mortgage rates are incredibly low and rents have risen in the past two years due to more demand and shorter supply. Indicators like these point to a strong and sustained rental market.

Consider you bought a $125,000 home for cash that would rent for $1,250 per month. With $15,000 income and allowing for property taxes, insurance and maintenance, it is still reasonable to expect $10,000 net income. You’d have an 8% return on investment without considering tax savings or future appreciation compared with 5-year CDs paying less than 1.5% and a 10-year Treasury yield at 1.65%.

The reasonable control has a lot of appeal to many investors who find the volatility of the stock market unacceptable and don’t want the risk associated with some of the alternative investments. Please contact me if you’d like to know more about available opportunities.