Cutting Edge Insights
with Dr. Lee

Putting the pieces together

Is the whole greater than the sum of its parts?

During these last few months, we’ve devoted 5 blog posts to explaining the 5 different profit centers unique to real estate (leveraged appreciation, cash flow, amortization, depreciation, and inflation hedging).

Now is the time to bring them all together and look at the big picture.

And what better way to do this than by applying them to an investment opportunity recently presented to me.

Single family home, 3/2, new construction, climate zone 2, 0.8% RTV,  $169,000.

The “seller” is a company that has been in the “build to rent” space for some time and also performs property management services.  They build in the high demand, heavily populated areas in the southeast United States.

3/2 means 3 bedrooms and 2 bathrooms.

RTV stands for rent-to-value ratio.  This home should command $1,350 per month rent.

Let’s take the builder/manager at their word (we can check references) and assume that with historical occupancy rates, 8% management fee (I’m not fixing the toilets or collecting rent), and a 30-year fixed mortgage at prevailing interest rates, the cash flow is $200 per month.

Q: How do I figure out my various returns?

A:  How much cash are you going to place in the deal?  (How’s that for answering a question with a question?)

You put 20% down.  That’s $33,800.  You have $4,000 in other closing costs, making your total cash invested $37,800.

  1. Leveraged appreciation: Let’s be conservative and assume that home prices continue to enjoy a 2% annual appreciation rate.  Yes, home prices have been increasing much more than this.  There also have been years in which prices have pulled back.  A 2% appreciation rate for underwriting purposes is conservative. But your return is greater than 2% because you control it with 20% equity.  However, we need to factor in the closing costs. Your return is [(2% of 169,000)/($37,800)] x  = 8.9%
  2. Cash Flow:  Let’s take the provider’s word for it here.  Sure, we can do a deeper exercise in underwriting, but that’s beyond the scope of these calculations.Your return is $200/month x 12 months = $2,400 / $37,800 = 6.3%
  3. Amortization:  We could make this one harder than it has to be.  Prevailing interest rates may be in the 3-4% range, but a good historical average rate is 5.5%.  But that’s irrelevant – as long as you stay rented, you’re covering 100% of your monthly outgoings because you have cash flow as stated above. Therefore, your real return from amortization is $135,200 (the amount that you financed) over 30 years – or ($135,200/30)/($37,800) = 11.9% per year.  Note that you could, upon reaching higher equity levels, refinance and produce more cash to make more purchases.  It may be tempting to think that taking on more debt would lower your return – actually it would increase your return exponentially.  The assumption here is that you never refinance, and you pay off the debt in 30 years.
  4. Depreciation – while you could perform a cost-segregation study and load up on the depreciation in the earlier years, let’s assume you follow the standard 27.5-year depreciation schedule and deduct 6.636% of the price every year – that’s 6,144.84 per year.But that’s a deduction from your taxable income – we’ll have to assume a tax bracket for you – if you’re in a 30% combined state and federal marginal tax bracket, you would save 1,843.45 from your income tax bills.That amounts to a 4.9% return on your original cash in the deal.
  5. Inflation hedging – this one could be nebulous to calculate, and it does compound over time.  I like to make safe, conservative assumptions.  Let’s assume that your fixed rate debt devalues at the same rate as inflation – 2% per year.  I feel confident making that assumption.

Now let’s add up the returns:  8.9% + 6.3% + 11.9% + 4.9% + 2% = 34.0% cash-on-cash return.

And that result is from using conservative numbers – I’ve seen others write about this and conclude their return is upwards of 40-50% per year.

Here is what is more important to me:  

The average stock market return, depending on who you ask, is between 9-12%.

Note that I said average – don’t be brainwashed by this – stock market proponents like to use the word average because it allows them to use higher numbers than if they said actual.  Don’t be confused by the illusion of average versus actual (actual is always lower – I’ll explain in a future blog post or you could simply visit www.CEassets.com/blueprint and download our eBook for a full explanation with illustrations).

My numbers above that result in 34.0% are actual numbers.  

(Sorry, Wall Street, you lose.)

Q. But, you might say, I could experience a period of vacancy.

A. Yes, you could – you may have periods where the return fluctuates due to factors such as vacancy or you may have an air conditioner fail – not likely in new construction – but maybe in 10 years.  So, plan for that and set money aside accordingly.

Q.  Do your projects ever exceed these returns?

A. Yes, and the answer to the question how does involve more discussion that’s beyond the scope of this article – send an email to Lee@CEassets.com to learn more.

Sometimes, our return is infinite.

Q.  What?

A. Stay tuned, I’ll explain later.

As you think about that, remember that real estate has built more wealth than any other asset class ever since humans have been tracking investment returns.

Until next time,
Dr. Lee Newton

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References

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Putting the pieces together

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