That sounds like a late-night TV pitch, but it’s actually possible in residential real estate. Housing is distinct from other investment vehicles in important respects. Unlike securities, real estate is a hard asset with an enduring intrinsic value. There are huge tax benefits accruing from owning real property, either as an owner-occupant or an investor. Most significantly, real estate can be leveraged up to 100% of its value.
Yes, you can buy a home with “nothing down.” Through the masquerade of a seller concession, you can even roll the closing costs into the loan, so that you can take possession of a rental property with absolutely no money out of pocket.
Why would you want to do this? Because the purpose of investing your money in real estate is not to own it but to profit from it. Real estate investment books are filled with bad ideas — never buy a cash-flow negative property, buy the cheapest home you can find, buy four-plexes in challenged neighborhoods, pay ahead on your mortgage to increase your equity. These are all terrible ideas because your sole objective should be cash-on-cash return: How much money did you take out of your pocket at the start of the investment, and how much money did you put back into your pocket at the end.
Is a cash-flow positive property a bad thing? No, but a home that is cash-flow negative — if you can afford the negatives out of other sources of income — can be a much better cash-on-cash investment.
Buying cheap is usually a terrible idea. The money from real estate investing comes from appreciation, not rents. Unless you convert the property to a higher and better use, what starts cheap usually stays cheap.
In the same way, buying multi-family properties or other homes in bad neighborhoods is unlikely to be a winning strategy. Your ratio of rents to costs may be better, but your appreciation will almost certainly be worse than buying in a more-avidly-desired neighborhood.
And paying ahead on your mortgage is just dumb no matter where you buy. With a 100% leveraged property, every penny of appreciation is 100% cash-on-cash profit to you. If you have any excess cash, you should be using it to buy more properties.
So what kind of investment property do you want? In the Phoenix area, the best-performing rental homes are newer homes in highly-desired middle-class suburban subdivisions. Unless you put a huge amount down, the properties will surely be cash-flow negative. They will not be cheap — on the order of $200,000 to $250,000 right now. Obviously, we only want to buy single-family housing, because we want for our rental to be surrounded by owner-occupants, and because we want to sell to owner-occupants on the way out. And I don’t even want to think about paying ahead on the mortgage.
There are a lot of houses like this for sale right now. For the most part, the sellers aren’t desperate, but if you’re willing to shop, you can pick up a deal. Alternatively, you can buy a home subject to a lease in place, which solves your first problem as a landlord.
I’m representing a house like this right now — I’m doing another one on Thursday. The seller of the first house bought it in January of 2005 for $136,000. We’re selling it for $200,000, with the seller conceding back three percent for closing costs. His marketing costs plus closing costs on both sides will run to around eight percent, total, so his net on the home will be around $48,000 — after only twenty months in what people who don’t know any better insist is a terrible real estate market.
But we’re not worried about his money, we’re worried about yours. If we buy that house for nothing down, we’ll call your initial outlay $1.00. Your mama always told you can’t get something for nothing, and spreadsheets don’t like division by zero. We’ll pay 7% for the 80% first loan, 10% for the 20% second — your mileage may vary. That’s $15,200 a year in debt service. We’ll pay the real life numbers for taxes, insurance, maintenance and HOA fees: $2,428 a year. We’re going to collect $1,000 a month rent for the life of the investment, even though rents should go up. We’re going to hold vacancy at 10% even though it’s less than that now and is trending downward. In other words, we’re not going to kid ourselves about anything. These are real life numbers with no blue-sky assumptions.
Annual net income is $10,800, allowing for vacancy, while expenses are $17,628. Your negative cash flow before taxes is $6,828 — $569 a month negative cash flow. This is where the investment-book authors freak out, but think of this this way: If you had an IRA or some other paper investment, what would your monthly negative outflow be? Your goal is to own a leveraged asset that will produce the greatest possible cash-on-cash return. A tenant can offset some of your costs, but you will not make nearly as much money, cash-on-cash, on a cash-flow positive rental.
Here’s good news, though: At tax time, more than half that negative goes away in depreciation. If you have chattels in the house like a refrigerator, washer and dryer, those can be depreciated on an accelerated schedule, for even more tax benefits. You’re now down to about $274 a month in negative cash flow. If your spouse glares at you, I’ll be happy to explain why we’re doing this — as many times as necessary.
For the sake of this discussion, I’ve assumed a fairly soft long term rate of appreciation — five percent, where the Phoenix area has historically averaged six percent. The people who are convinced that the sky fell yesterday will not be moved, but the rate of appreciation matters a great deal in determining when we’re going to sell this house.
When would that be? When we get to the back side of the depreciation schedule. We can only depreciate 80% of the original purchase price, so, as the value of the home escalates, we lose some of the tax benefit of the asset: It’s worth $300,000, which should be worth $240,000 in depreciation, but, because we bought the home for $200,000, we’re only able to take $160,000 in depreciation. The point at which it becomes more profitable to sell and reinvest than to hold is bright-line determinable, and we should sell when we get to that point.
Let’s call it eight years. The property will be worth almost $300,000, and we’re going to have to pay taxes plus marketing costs of about six percent on the way out.
Net cash to the seller? $26,802 — after everything, including all the negative cash flow. How much did you put in? Oh, that’s right, a buck.
I don’t expect people to take me on faith. This entire scenario is documented in this spreadsheet. There is a lot more about investement strategy on our investments page. I have investors who have made hundreds of thousands of dollars in highly-leveraged real estate investments. A few are on track to become millionaires by investing other people’s money. And while no one can promise future appreciation, the residential real estate market in Phoenix — reports of its demise to the contrary — should be robust for a long time to come.
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David Jones says:
How wise is it to buy a rental property on ‘nothing down’ though? Interest rates have been rising and if the current stagnation in home prices continues, wouldnt that be a poor choice to invest in due to higher monthly payments? What percentage of one’s income would be wise to invest in this manner (in terms of monthly payments)?
July 30, 2006 — 5:36 am
Greg Swann says:
> How wise is it to buy a rental property on ‘nothing down’ though?
All investment is the hope of reward in compensation for the risk of loss. If you can’t stomach the latter, don’t look for the former.
> Interest rates have been rising
I like 5/1, 7/1 or 10/1 fixed-adjustible loans even though the monthly nut is higher. That’s a risk-management strategy, and many of my investors have done very well with LIBOR-based interest-only ARMs.
> What percentage of one’s income would be wise to invest in this manner (in terms of monthly payments)?
Nothing that you can’t afford to lose.
One gorgeous way of doing this is with a self-directed IRA. The tax advantages can be amazing.
July 30, 2006 — 8:46 am
tinman can says:
What about the people who aren’t looking for a greed driven quick profit, but simply looking to buy an affordable home to raise a family without leveraging to their eyeballs? When was the last time you told a client to rent for a while because it might be in THIER best financial interest. My guess is never.
July 30, 2006 — 9:11 am
Robert Cot says:
Nothing we haven’t heard already on the infamous “thereisnohousingbubble:”
But enough sloganeering, let’s talk some real world numbers for a bit. Let’s say you do something wise, you purchase a home in California for $500,000. This beautiful and desirable home will appreciate by about 20% per year. Therefore after 30 years that home that the renter unwisely turned his nose up to will be worth a little over $100 million. Now let’s say you are even wiser than this. Let’s say you use the rapidly rising equity in this dream home to purchase another undervalued home every year. So you’ll earn 30*$100 million or over 3 BILLION dollars. That’s right, you’ll become one of the richest people in the world and all you did was sit back and let debt work for you. Imagine all of the wondrous things you could do with $3 billion. You could buy a whole fleet of Hummers, a plasma TV for every room of your house. Perhaps lunch in Paris and dinner in Tokyo while you jet around in your private plane? Whatever your heart desired all brought about by the magic of home ownership.
July 30, 2006 — 9:40 am
Osman says:
Greg,
I haven’t gone through your whole investor spreadsheet yet, because I found something wrong with your math. The annual payments on the loans in your scenario should be $16,989.15, not $15,200. Use the PMT function on your calculator or Excel sheet and make sure the interest (i) and number of payments (n) are the same time period (monthly). In other words, calculate based on 360 payments (n) and 7%/12 or 10%/12 (i).
Now on a positive note, I like the way you’ve presented the information. It’s intuitive and nicely laid out.
I build an Excel model that I use with clients. It allows them to evaluate and input their own assumptions for appreciation, maintenance, holding period, etc. Another way to go about it. I might take the time to write up a “guide to the model” with a step by step. Could be helpful.
July 30, 2006 — 12:01 pm
Greg Swann says:
> The annual payments on the loans in your scenario should be $16,989.15, not $15,200.
I’ll look into this. That spreadsheet was written by Andrea Laue of the Council of Residential Specialists. It’s a takeaway from CRS 204, my favorite of the CRS classes.
July 30, 2006 — 3:37 pm
Misleading says:
“The money from real estate investing comes from appreciation, not rents.”
“If you have any excess cash, you should be using it to buy more properties.”
“Many of my investors have done very well with LIBOR-based interest-only ARMs.”
“Your goal is to own a leveraged asset that will produce the greatest possible cash-on-cash return.”
“I have investors who have made hundreds of thousands of dollars in highly-leveraged real estate investments.”
“While no one can promise future appreciation, the residential real estate market in Phoenix — reports of its demise to the contrary — should be robust for a long time to come.”
How do you sleep at night? The last quote (“while no one can promise future appreciation…”) reminds me of something the corrupt, incompetent lawyer Lionel Hutz said on “The Simpsons” – “and while I can’t guarantee you a big cash settlement, I guarantee you a big cash settlement.”
July 30, 2006 — 5:14 pm
Greg Swann says:
> The annual payments on the loans in your scenario should be $16,989.15, not $15,200.
Coming back to this. Your scenario presumes amortization, where the spreadsheet is using interest-only for clarity’s sake. The principal is all paid back on page 5.
Someone mentioned bumping the opportunity cost from 2% to 5%. That seems reasonable. With that change, the net is reduced to $24,603. Dang.
July 30, 2006 — 6:39 pm
Osman says:
well, amortization and compound interest are how most (all?) mortgages and loans work. I’m pretty sure even IO loans and balloon mortages function the same way. If a buyer isn’t even covering the interest, the difference is added to the principle value of the loan. That’s how negative amortization works.
If you find out different, please let me know.
July 30, 2006 — 9:04 pm
Greg Swann says:
> If you find out different, please let me know.
I concede that I might be wrong here. I ran the numbers in two mortgage calculators at Bankrate.com, one amortizing, one interest-only. The first produced your numbers, the second mine. I can write software in a bunch of different languages, but I know nothing about spreadsheets (or databases for that matter), so I’m at a loss.
July 31, 2006 — 4:39 pm
fatcats says:
Well, there are some really fundamental problems with your scenario –
1. You’ve presumed 5% appreciation but if that drops to 4%, your ‘profit’ after 8 years is zero. Sure, you say the growth trend is 6% but who knows if the next 8 years be as good as the last?
2. If interest rates rise by even 0.125% your ‘profit’ drops to $6K. Keep in mind that over an 8 year period you’re going to spend about an additional $20,900. for every 0.125% rise in interest rates!
3. To sell the house after 8 years of renting will require some ‘freshening up’. New paint at the very least and perhaps new carpet. You should budget at least 1% a year for this – which is $16K. Oops, profit down to $10K.
4. You’ve failed to calculate the risk premium. Sure, if everything goes to plan the investor makes a miniscule profit (13% over 8 years). However, an investor has to evaluate your rosy scenario against the potential downside risk of owning a $200K leveraged property.
If you calculate the likelihood of your scenario as 75% against say 25% for a slightly worse scenario (4% appreciation/0.125% rates rise) the expected rate of return would be 7.25% or $14,500. But of course we still need to spend about $16K to ‘freshen up’ for sale. Ergo, probably no profit on this investment.
In short, the slightest error in your estimates for appreciation/interest rates can put your investor into a big loss. Advising a 100% financed, $200K purchase on the back of a 6% rental yield is really, really bad investment advice.
And do you really think it appropriate for RE agents to be giving investment advice?
July 31, 2006 — 10:24 pm
Greg Swann says:
At 4% appreciation, the net profit is $9,402. At 6%, it’s $45,401. The scenario as presented does not take best advantage of the tax laws, so real life results could be much better.
Maintenance is built in to the calculations.
Interest rates don’t change on fixed-rate loans, but, even so, bumping the rates by an eighth of a point at 5% appreciation reduces the net yield to $25,287. You multipled time .0125 where an eighth of a point is .00125. At 4% appreciation and an eighth of a point higher, we’re still at $7,887. Even allowing for a 5% opportunity cost on the negative cash flow, we yield $5,568 at 4% appreciation — 100% free return on a $1 investment.
The scenario is deliberately pessimistic. My real life results have been much, much better. Appreciation has been better, of course, but the vacancy rate for rentals I pick is very low. I project the way I do for a reason: I want my investors’ results to beat my estimates.
Nice try. I do this for a living. If I weren’t good at it, I’d be much thinner.
July 31, 2006 — 11:37 pm
carefulwithnumbers says:
please don’t be silly. clearly, anyone who applies your advice invests more than $1. you don’t help yourself by repeating this nonsensical claim.
July 31, 2006 — 11:52 pm
Greg Swann says:
> please don’t be silly. clearly, anyone who applies your advice invests more than $1. you don’t help yourself by repeating this nonsensical claim.
Every cent is accounted for. You could argue that the effort and stress of being a landlord are not in the calculations, but they wouldn’t be in the calculations for any other investment, either. We do math on things that can be measured or counted. But the fact is, if our historical rates of appreciation hold in the long-run, investors who pursue a strategy like the one outlined here will do much better than this projection. I am extremely careful with numbers. I made a point of demonstrating this.
In fact, in real life, an investor would deploy his dollars differently. The point of this example was precisely that: To serve as an example. My experience with my new-found friends has been enlightening: Many of them can’t do math or reason their way from A to B. The repeated demonstration of obvious, documented, verifiable facts leaves them unmoved. They believe what they want to believe, facts be damned — and damned very loudly. This investment scenario is a reduction to naked principle: The profits to be made from investment real estate are potentially so great that it is possible to realize huge gains even working from very pessimistic assumptions.
August 1, 2006 — 12:15 am
carefulwithnumbers says:
shall we all factor in opportunity costs when talking about the number of real dollars we invest?
i’m not suggesting your math doesn’t work, but let’s not hide numbers behind numbers.
and don’t get me wrong, it’s actually good of you to include them when you’re trying to determine your overall return, just kind of snake oily when it’s also used to boast “look at all this money i made off of $1!”
August 1, 2006 — 12:17 am
Robert Cot says:
As the someone who mentioned the 5% opportunity cost might I also suggest a tax rate of 1.4% instead of 0.4% to reflect the average of Maricopa County. Also there’s no inflator on the optimistic $600/yr insurance number. Non-owner occupied property/casualty AND liability for a $200,000 structure would more likely run $800-$900 in the first year and rise 5-6% annually. Using realistic tax rates yields an additional deductible expense of $16,000 with no increases or a more realistic $20,000 at approx 4% annual increases. Insurance adds an additional $2500 +/-. 6% selling costs are also fine even conservative -if- you are a Realtor but even the NAR uses 8-9% as a general costs. That’s another $5,000-9,000. Franklin’s AZ tax free municipals are yeilding 4.42%. Use that as your opportunity cost. The 28% deductibility and tax rate only applies if all your personal deductions keep you in the 28% bracket. That’s quite an income and unrealistic. Better to assume half at 15% and half at 28% to better represent all but the highest income earners. Ditechs rate for 100% investment grade is 7.5% or $16,800 per year. At least it is fixed and amort and only $8000 in fees. You’d be hard pressed to get anything lower withouy having to account for even more substantial closing fees.
All this tells us is what those of us who’ve been doing this for decades already know. You make your money on the purchase not the sale. This proposal for all its spreadsheet mathematics can be replicated by; price divided by rent. In this case 200. A good deal is 100, fair 120, special circumstances allow 140. In other words this Phoenix area house is overpriced by 30-50%. Gee, where have we heard those figures before? That’s right the bubbleheads are also saying Phoenix real estate has gotten 30-50% ahead of long term fair value. Then we can discuss the $1000 rent both price and likelyhood of stability and the $200,000 price in a city where the median price is $220,000. I know I wouldn’t touch this deal and I doubt anyone with the wherewithal to do deals like this would either. When the regions largest employer is Wal-Mart and #2 Honeywell is in the midsts of a personell needs reevaluation and the fallout of Intel laying off 1000 managers and the ripple effect on Motorola, I’d be a more than a little worried about even your normally generous 10% vacancy assumption as well.
Don’t get me wrong, Phoenix has been a great place to invest and will be again, just not now.
August 1, 2006 — 12:44 am
fatcats says:
I think your maths on appreciation are wrong – at 4% appreciation the house will be $273K, less 6% transaction fees, less $569. x 96 months, less $200K purchase = about $2,700. I agree that at 6% you’ll net $45K. (and yup, mea culpa, as I goofed on the interest rates).
I also don’t believe you can carry anything close to adequate maintenance in the figure lumped under “taxes, insurance, maintenance and HOA fees: $2,428 a year”. Sorry, but I own rental properties and it just doesn’t square with my experience.
Its disingenious in the extreme to suggest that any variation from your scenario is far more likely to be on the ‘happy’ 6% side than to the other side of the ledger. Even if one doesn’t subscribe to the idea of a crash we’re certainly entering a time of uncertainty which could very likely see things performing to the weaker side of normal rates of appreciation. And any investment not factoring in a very large margin of safety is a really bad idea.
“Nice try. I do this for a living. If I weren’t good at it, I’d be much thinner.” – I thought you sold real estate, not investment advice.
August 1, 2006 — 3:15 am
Greg Swann says:
> shall we all factor in opportunity costs when talking about the number of real dollars we invest?
It’s on page one of the spreadsheet. I’ve run it at 2% and 5% to show that it doesn’t make much difference.
To illustrate a dramatic difference, by putting 20% down, you could make the original scenario essentially cash-flow neutral — no negative cash flow and no opportunity cost beyond the down payment. But the net would only be $91,037, which sounds like a lot but is only 10.83% annual after-tax yield. That’s still pretty good, compared to other things you might do with that money — particularly if it’s 1031 money — but if we had bought 4 houses at 5% down instead, the net return could have been $171,444, almost double. All of this is hypothetical — a word you might look up — to illustrate the wealth-building power of leveraged real estate investing.
August 1, 2006 — 8:41 am
carefulwithnumbers says:
> and don’t get me wrong, it’s actually good of you to include them when you’re trying to determine your overall return, just kind of snake oily when it’s also used to boast “look at all this money i made off of $1!”
perhaps you should read the entire post? (and i *try* to keep them short!)
i acknowledged that you included opportunity costs in your model. i just have a problem with your $1 becomes $27K.
shall i open an investment account with $1, invest money on a monthly basis, (hopefully) get a nice return and then say i made it all on my dollar?
it’s the headline of your frickin’ post and i wouldn’t have even called it out because i’m okay with attention grabbing headlines, but you repeat it later like you really have figured a magic way to milk a good bit of money out of a single dollar.
suggesting i look up hypothetical misses the point.
August 1, 2006 — 9:35 am