• Home
• About Myself
• Ask A Question
• Blog
• Disclaimer Statement
• Privacy Policy

My First Real Estate Investment in 13 Years

In a recent post I described in detail a real estate investment of a single family home I have owned for 20 years. In my opinion it has been a pretty good investment for us. In this post I will describe my first real estate purchase in 13 years.

I did not even consider investing in any real estate in the 10 year period from 2001 through 2010 because I felt real estate was overpriced. Why did I think this? I will once again reproduce below the chart from several of my past real estate posts comparing the average US home price versus the average US price to rent an equivalent home.

If you are going to invest in real estate, this chart captures the most important information about the long term real estate cycle and the best time to invest in real estate. When the two lines are close together (or the blue line is below the purple line), it is a good time to invest in real estate. When the blue line is above the purple line, it is a bad time to invest in real estate. The chart data is produced by the federal government and is an average for the entire country, so it is possible it may not apply to your area. Nevertheless, the chart provides a good macro indicator about when to consider investing in real estate.

After the real estate bust of the last few years, many people think that real estate is a risky investment. Every investment has risk. But, based on the above chart, I now believe real estate prices have returned to reasonable valuations and thus the investment risk is greatly reduced. This does not mean real estate prices will shoot up in the near future. On the contrary, I think real estate prices will be flat for the next few years. But, if you view real estate investing the way I do, i.e., as an income investment, it does not matter that real estate prices will not increase. As long as the income the property generates provides a reasonable “cash-on-cash” return, I will consider any real estate investment.

To illustrate how much I believe now is a good time to buy real estate (whether as an investment or as a home), I will provide the figures for a property I have recently contracted to purchase. The property I purchased is located in a small Maryland town with a population of about 15,000. Since I have not yet gone to settlement on this property, some of the figures below are estimates.

Acquisition Costs

 
Annual Operating Costs

As I have stated in previous posts on real estate investing, the most important area of the investment to evaluate is the property rental income. When buying real estate, most of the ownership costs are known, but the property income is not known if the property is not currently rented. You must have a very good idea what the property will rent for to be able to evaluate the investment properly. I had an 18 day contingency period in my purchase offer that allowed me to examine all the property costs and rent closely before I committed to the purchase.

This property has been converted into 2 one bedroom apartments. After some research, I concluded I can rent the larger unit for $950 per month and the smaller unit for $850 per month for a total gross monthly rent of $1,800 or $21,600 per year. An easy rule-of-thumb to use to decide whether to consider a real estate investment is to compare the gross annual rent to the purchase price. If the gross annual rent is near 10% of the purchase price, this is usually a good indicator that the investment will work. In my case the $21,600 gross investment income/$210,000 purchase price = 10.3%.

Since I will be an out-of-town landlord, I have chosen to hire the services of a property manager who charges 10% of the monthly rent for their services. So, after paying the property manager, the monthly rent available for other expenses will be $1,620 or $19,440 per year.

The total annual operating costs from the table above are $6,562. Subtracting this figure from the $19,440 annual rent provides an annual net income of $12,878. Since I am paying cash for this purchase, the $12,878 net income represents a 5.9% return on the total property acquisition cost of $219,000. An income yield of 5.9% tells me that I purchased this property at a very good price. Remember this 5.9% return does not include any property appreciation and the income yield should increase over time.

There is one other benefit to this investment. There is a tax deduction benefit – the property depreciation. Real estate investors can take a ‘non-cash’ expense based on depreciating the property improvements (the land value cannot be depreciated). The building value is a percentage of the purchase price.

In my case I have determined the building value to be $150,000. The current federal tax code allows the building value to be depreciated over 27.5 years. So each year I own this investment property, I will claim a $5,455 tax deduction ($150,000/27.5 years) against the property income that costs me nothing out of pocket. That is, this $5,455 depreciation deduction reduces the above $12,878 annual net income to only $7,423 of ‘taxable income’ even though I can spend the entire $12,878. This is why depreciation is called a ‘non-cash’ expense. (As a side note, I never consider the property depreciation tax benefit when evaluating a real estate investment’s return; I only consider the cash components).

What if you are purchasing this property with a loan as your primary residence? I think this transaction would still be a good one as long as you are OK with living in a one bedroom apartment. This is how the figures would look for this property as an owner occupant with 95% financing.

Owner Occupied Acquisition Costs

 
Owner Occupied Annual Ownership Costs

If the smaller apartment is owner occupied, then the monthly rent for the property is $950 or $11,400 per year. If the property is owner occupied, then there would be no need to pay for a property manager.

Subtracting the total annual income for the rented apartment of $11,400 from the total ownership cost of $20,929 means the owner would have to pay about $9,529 per year or $794 per month net out of pocket costs for a place to live. The fact that the $794 per month net cost (including utilities) is less than the $850 per month you would pay as a renter is further evidence that owner occupying this property is better than just being a renter of the apartment.

If a couple years later you moved out of the property and rented both units, the monthly cash flow would look something like the table below.

Monthly Operating Cash Flow

The net monthly rent (assuming you handle all property management duties yourself) is $190 or $2,280 per year. From the Owner Occupied Acquisition Costs Table above the total cash required at settlement was $20,500. The net income of $2,280 represents an 11% cash-on-cash return of the original funds invested (i.e., $2,280/$20,500 = 11%).

In addition, after 24 months, the loan balance is being reduced about $3,800 per year by the rent payments. This adds another 18.5% return on the original cash invested ($3,800/$20,500 = 18.5%). As you can see the smaller the down payment to purchase a property, the larger the percentage returns. This is the power of financial “leverage.” But leverage can be a double-edged sword, so you must be careful when financing properties with small down payments.

Finally, this investor will get the same $5,455 annual depreciation expense that I will get in my real life purchase. The depreciation expense is not affected by how the property is financed. In this example, since $5,455 is greater than the $2,280 net annual cash flow, the entire $2,280 cash income will be 100% tax free. The net property income will continue to be 100% tax free until the net income surpasses the $5,455 annual depreciation expense.

This example shows that investment real estate, if purchased properly and at the right time in the real estate cycle, can provide significant returns even if the property does not increase in value. If you have a stable job and good credit now is the time to invest in real estate, but only if you can hold it for the long term.

If you are wondering where I obtained the funds to purchase a real estate investment for 100% cash, I used funds from the recent sale of our primary residence. Why would I sell my primary residence when I have been arguing that now is a good time to purchase real estate? The reasons pertain to our particular situation. But I think the reasons we sold our primary residence and purchased the investment property described in this post could be applicable to the situation of many people nearing retirement. So I will make this the subject of my next post.

Did you enjoy this post? Why not leave a comment below and continue the conversation, or subscribe to my feed and get articles like this delivered automatically to your feed reader.