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A Real Estate Investment After 20 Years; Was it Worth It?

Next month marks the 20 year anniversary of the purchase of my first long-term real estate investment. In this post I thought it might be instructive to describe the actual transaction I made 20 years ago, the major events during the life of this investment, and the financial benefits my wife and I enjoy today. The reason I think this may be helpful is I will talk about some of the decisions I made as well as the aggravations I experienced along the way. For a new real estate investor it is important to be able to see the end game to keep yourself motivated when you encounter the inevitable frustrations. Also going over some of the important events of this investment will shed some light on some of the choices my wife and I made over the years and the impact it had on our lives. You can decide for yourself whether the investment was worth the time and money.

In 1992 I had just completed the investment period of my life I refer to as my “California real estate fiasco.” If you want to read about this painful period in my life and the lessons learned, go to this post. As a result, at this time of my life I was cash poor so my first serious real estate investment required me to take on a partner. I joined up with a friend of mine who was cash rich and we purchased our first real estate investment that we intended to hold long term.

In the following paragraphs I am going to describe this investment in detail using the actual investment figures, from 20 years ago until today, rounded off to the nearest thousand dollars (the nearest hundred dollars for monthly figures). For anyone who does not reside in a large city, the figures cited in this investment may seem high, but this is just the market in major US cities. Regardless, the investment decisions I made are the important thing to pay attention to.

In the summer of 1992 my partner and I purchased a townhouse in a good neighborhood of Washington, DC for $220,000 with a 10% down payment (in 1992 there were non-traditional lenders who would lend investors 90% of the property purchase price). So our initial loan amount was $198,000. I do not remember the amount of the monthly taxes and insurance, but I do remember the initial P.I.T.I (Principle, Interest, Taxes & Insurance) payment was $1,700 per month. This property happened to have a separate “in-law” apartment in the basement. I immediately rented out the 3 bedroom and 2 bath upper apartment for $1,400 per month and these tenants paid for all utilities for the entire building.

At the time the one bedroom basement apartment would have rented for about $600 per month, but I moved into the basement unit. My partner agreed to this as he resided in another state and I was managing all affairs related to the property. The basement unit was already equipped with a kitchen and bath so we did not have to invest any money in it, but it was not a very nice apartment. The apartment had no windows, the kitchen was from the 1950s, and the bath was the size of a small boat bath. But I was only paying $300 a month (the difference between the $1,700 mortgage payment and the $1,400 monthly rent from the upper unit) for an apartment that had a market value of $600 per month. At the time I was 37 years old and single.

For most people, unless you are fresh out of college, living in a small dumpy apartment is either not acceptable or, if you have a family, not practical. However, my decision to occupy the basement unit turned out to be an important life choice that greatly accelerated my wealth accumulation goals. In 1992 I had a good paying job and the $300 per month I was paying for housing was very small compared to my earned income. This allowed me to accumulate savings at a much faster pace.

I would probably still be living in that basement apartment if it were not for the fact that the next year I met my future wife. I and later with my wife lived in this apartment for 3 years. During that time we were a dual income couple paying only $300 per month (with no utilities costs) for a place to live. My wife only tolerated the apartment until she saved enough money to buy another house to live in. It only took her a year to save the $9,000 total needed to buy another DC townhouse for $180,000.

In 1995 we moved into the new home and I rented out the entire investment property for $2,400 per month. After 3 more years (1998) the property was renting for $2,700 per month and our PITI monthly payment was $1,800. The property was generating a $900 per month cash flow which my partner and I split after escrowing $300 per month for maintenance and repairs.

In 1998 my partner surprised me by telling me that he wanted either to sell the property or for me to buy out his share. I was certain this was not the right time to sell the investment. Why did I think this? Below I provide a chart from an earlier post based on government data. The chart shows how the average price of a single family home nationwide relates to the average rent for a single family home. From about 1992 to about 1999 the average house price index (the blue line) is lower than the rent index (the purple line) which indicates it is a good time to own a home versus renting the same home. Of course, I had no idea what was in store for real estate values in the 2000s, but I knew in 1998 real estate was a good investment because the annual rents covered all the costs of ownership which is rare especially in expensive real estate markets like Washington, DC.

After I decided to buy out my partner’s interest, we got an independent property appraisal. The property appraisal provided more evidence that convinced me that 1998-1999 was not the time to sell a real estate investment. Six years after we had purchased the property in 1992, the property appraisal was only about 10% higher than our original purchase price. After the appraisal I suggested that my partner reconsider his desire to be bought out, that he would just be getting his original investment back. He acknowledged that it may not be the best time to sell real estate, but he had other reasons he wanted to be bought out.

So in early 1999, after reducing the property appraisal by the typical 6% real estate fee, I bought out my partner’s 50% interest in the property for $23,000 and assumed 100% obligation of the existing loan balance which at the time was $185,000. If I was so cash poor in 1992, how was I able to find the money to pay off my partner’s equity in the property in 1999? I did it the old fashion way; I saved the money from my monthly paycheck.

In the 6 years that my wife and I had lived in the basement apartment of the investment property and later in the home that my wife purchased (which had its own basement apartment that we rented out), we had only been paying between $300 and $600 per month net out of pocket for a place to live. Plus, once we moved into the house my wife purchased in1995, we started receiving about $200 to $300 per month net cash flow from the investment property. This meant, after allowing for the net income from both properties, we were paying next to nothing for a place to live. At this time my wife and I both had good paying jobs. This low living cost arrangement allowed us to max out our retirement plan contributions, pay off my wife’s remaining school loans, and for me to save more than enough money to pay off my investment partner.

This was all during the 1990s dot.com boom and before the 2000s real estate boom. I remember talking with several stock brokers at the time. They were telling me that I was a fool to be purchasing real estate in the late 1990s and not stocks, especially technology stocks.  My wife and I were in fact buying stocks during this period in our retirement accounts (although not dot.com stocks).

But this is where we got the best advice of our lives. In 1998 my father, who was a very savvy investor, was still alive and he told me not to listen to the stock brokers, that the stock market was vastly overvalued and that we were doing the right thing buying real estate at that time. My father was the type who rarely gave this kind of advice, so when he did, you did not ignore it.

Like everyone else in the early 2000s our stock investments in our retirement plans tanked, but we were well positioned to ride the coming real estate boom which made up for all our stock market losses several times over. But, as I have recommended in previous posts, we kept contributing to our retirement accounts, so we easily recovered all our stock losses by 2004 when the stock market was in the middle of the next bull market rally.

The next big event in the life of this investment was in 2002. When the tenants moved out, the basement apartment was in such bad shape, I think even I would not have lived in it. So I spent about $40,000 on the property renovating the basement apartment and installing a new kitchen in the upper unit. I refinanced the loan on this property a couple times over the years to lower the interest rate, but I never took any cash out of the property as was popular during this period. If I did not take any cash out of the rental property, where did I get the$40,000 to renovate the property? This is where we were most fortunate as we were able to take advantage of the approaching real estate boom.

In 2002 real estate prices started to soar. I got concerned that a real estate bubble was forming, so we sold my wife’s home in Washington, DC and moved to our vacation property in Annapolis, MD which we had purchased in 1997 at a very low price with less than $6,000 down payment. We sold our DC residence because it was our primary residence and we could sell it tax free.

As you can see in the chart above, selling this property in 2002 was too early. The real estate bubble had 3 or 4 more years to go. We missed the top of the bubble, but when deciding to sell an asset during a bubble, it is always better to get out too early with a guaranteed profit than sell too late and lose all the profit. In any event, the sale of our DC home in 2002 provided enough cash to pay off the loan on our new residence in Annapolis, MD and the $40,000 to renovate the DC investment property. The proceeds of this sale also provided enough funds to pay down the investment property loan by $15,000.

In the spring of 2005 the real estate bubble in the Washington, DC area was coming to a frenzied peak and looking at the above chart in 2005, I knew this bubble could not last much longer. So I considered selling the DC investment property in 2005. At this point I had owned the property for 13 years.

In 2005 the property was worth about $800,000 and my loan balance was $166,000 but my “cost basis” was $264,000. The PITI monthly payment was $1600 and the rent had increased to $3,400 per month. After allowing for $400 per month for maintenance and repairs, our net monthly cash flow from the property was $1,400 or $16,800 per year.

Without going through all the detailed calculations here, if I had sold the property in 2005 after paying off the loan, paying all federal and state taxes of about $125,000, and paying the real estate fee, we would have netted about $450,000 from the sale. In retrospect, since the house value did drop in the years after 2005, it probably would have been better to sell the property. But the thought of paying that huge amount in taxes really bothered me. Also I did not know what else to do with the lump sum cash.

In 2005 my wife and I were both still working so we did not even need the $1,400 per month to live on. This $16,800 annual income was going straight into our savings. In fact with the $8,000 annual depreciation expense provided by the property meant only about $800 of the $1,400 net monthly rent was even taxable. Additionally, the loan was being paid down by about $3,000 per year. Our net worth was increasing by $250 with every monthly payment our tenants made. So we kept the property.

Since I first got involved with the property in 1992, I had handled all property management issues. Over the years the tenants burned part of the carpet in the upstairs family room while playing a drinking game. For years I paid to repair a constant roof leak that I could not seem to fix. I finally just replaced the roof (I would have saved money by doing that up front, but the leak was very small). One winter a pipe froze and burst in the basement apartment living room requiring me to renovate an entire room from floor to ceiling. There are many other stories, but I think you get the picture, being a real estate investor is not all fun and games.

On the plus side in 20 years of owning the property, I had only 3 months that the property was vacant. Only one of those 3 months was the property unintentionally vacant. For the last 10 years that I managed the property I never even ran an advertisement to find tenants. In the spring of each year, about 2 months before the lease was up, I would get a call from someone who wanted to rent the property (in 2005 I started renting the property as one unit). I would always ask the prospective tenant if they would like to see the property, they always told me no, they had already seen it. They just wanted to know where to send the money.

When I retired in late 2010, I finally turned the property management over to a local firm. I would have kept handling the management, but my wife and I wanted to do some traveling and frankly I was getting tired of the property management. Now I don’t ever see the property and I don’t want to see it.

Currently the investment property is worth about $700,000 and the remaining loan balance is $145,000. After re-financing the property last year the current PITI monthly payment is now $1,450. Because the current tenant has lived in the property for 4 years, I have not raised the rent much the last four years. The current monthly rent is $3,800. After escrowing $400 per month for maintenance and repairs and paying the realtor a $250 monthly management fee, the net cash flow from the property is $1,700 per month or $20,400 per year.

The income alone is a 4% return on our pre-tax property equity and a 5% return on the after-tax equity. It would be hard right now to find a bank CD, a safe bond or stock that pays that much income. We are still getting an annual depreciation expense tax deduction of about $8,500. We are also gaining about $3,500 per year in equity with the loan payoff.

What is the bottom line on this investment? 20 years ago my partner and I put up $25,000 to buy this investment (I later bought out my partner but $25,000 was still the total amount for me to acquire the property). All the property operating costs came out of the property cash flow. In other words, from day one I never experienced any “negative cash flow” with the property.

Now, 20 years later, the $20,000 annual income from the property alone is almost as much as our original down payment to purchase the property. This is why, in my opinion, investors should focus on income producing investments (whether stocks or real estate) instead of trying to hit a home run by investing in growth stocks like Google or FaceBook.

Before ending this post, I want to say that there are probably many people reading this post that are thinking, “Well your investment results may have been possible 20 years ago, but that is not possible today.” Before you dismiss real estate as an investment, I want to make sure that you do not overlook the most important lesson of this post.

Referring again back to the above chart, the main reason my wife and I did so well in real estate investing is we purchased our properties when real estate values were in the “sweet spot” between 1992 and 1999. If you look at the last couple of years of the above chart, you can see that the lines are converging again. This means real estate is returning to its proper valuations. In other words the 15 to 20 year real estate cycle that began in the early 1990s is starting over again in 2012. For those readers in their 30s or 40s, this is the time to start accumulating real estate assets for the long term.

In fact last week I made my first offer to purchase a real estate investment in 13 years. I will describe the transaction I am considering in my next post.

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