Last week, I wrote a “meat and potatoes” post where three Houston investment properties in premium locations were dissected and analyzed thoroughly. (Read that post if you haven’t already. I’ll wait). Their locations were stellar: excellent schools, amenities and access. The numbers were solid: Positive cashflow, cash on cash returns between 8-10% and cap rates north of 7%. But anyone who reads this blog knows where I ultimately stand on this. It’s not about the properties. Real estate investing is all about the strategy. Here’s what I mean.
Real Estate Investing Before Blueprint
Let’s assume you purchased those three properties I analyzed in that post. To make the calculations simpler, we will assume they’re purchased at the same time. Let’s look at what was accomplished. Roughly $100k was invested ($86.5 in down payments + closing costs) to acquire a portfolio worth $432.5k which yields $8,855 in positive cashflow annually. Basically, this translates to a 9% return on investment: beats the hell out of your neighborhood bank’s CD and the stock market minus its bipolar volatility. The investor’s portfolio is expected to be paid off on your Lender’s schedule in 30 years. At that time, it will consist of three paid off 35 year old homes cashflowing at about 7% of whatever the properties are worth then. In the meantime, your cashflow amounts to little more than a nice bonus/part time income that can support your latte budget, a light bill and a couple of dinners out. So one may think: This strategy doesn’t work! To which I reply: What strategy?!
Real Estate Investing After Blueprint
It all begins with addressing The Timing. Any long term real estate investor is ultimately after cash flow but the real question is When. The overwhelming majority of clients with whom I have this conversation quickly realize that they don’t need the cash flow right now but instead, are looking to build enough cashflow when they arrive at destination. If that’s the case, then what could be accomplished by putting current cashflow to work to bring the destination closer and arrive at a paid off portfolio on your schedule? Glad you asked. Take a look at this (click on the image to see full size):
What just happened? I crafted a Blueprint investment strategy with those three featured homes using painfully simple but time tested principles. Since the investor doesn’t need the cashflow at the current time, we apply it to the mortgage balance on one of the properties while making the regular payment on the other two. In addition, I advise my client to add $500 from her monthly income as additional catalyst. The goal is to pour gasoline on the fire and obliterate that mortgage as fast as possible.
The result: The first property is mortgage free in 68 months – that’s a little over 5 and half years! What follows is an imitation of what happens in an avalanche. Since the first property is now paid off, the mortgage payment on that property now gets added to the cashflow with which we attack the mortgage on the second property. Since we are hitting it with even higher principal payments, that property is paid off in just 38 months. Rinse and repeat on the third property and voila: the last property is paid of in 35 months.
Moment of Truth
Let’s examine the difference that a well crafted strategy can make. After executing the Blueprint strategy, the investor would “arrive” at a paid off portfolio of properties worth $432.5k (at a very conservative zero appreciation) in 141 months (under 12 years). At that point, the annual positive cashflow would be $30k/year if rents didn’t go up one penny in 12 years. That folks, translates to a 19% annual return on $157k invested every year thereafter. The investor was able to just about triple that $157k in those 12 years leaving appreciation completely out of the picture. Skeptical about the numbers? Email me and I will send you a spreadsheet to look over.
Flexibility
The above analysis assumes perfect execution. But circumstances aren’t always perfect. Don’t want to invest the extra $500/mo? It will extend the journey by three years but lower your capital invested by 40%. So it’s a matter of what’s most important to you, time or money? Want to hold on to the cashflow for a month to ride through a temporary vacancy? You can totally do that. Cashflow of $30k/year is nice but won’t quite cut it? We can increase the asset value from which that cashflow is drawn by acquiring one or two additional properties. This concept is so powerful that detours may change it’s variables, but if you commit to execution, you will look back and won’t be able to stop smiling.
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I can craft a Blueprint investment strategy for you, too. Give me a call at 713-922-2702 and I will get to work. Make this a great week!
I am very interested in this “Crafting a Blueprint” article. Is there a computer program or spreadsheet that i can plug in the actual numbers on my rentals so i can see how this effects my investments?
Hello Frank
There is no program or spreadsheet that will craft a Blueprint based on your current investments. But I can help you with that 🙂
My cell is 713-922-2702. You can call me anytime.
Hi, i have read your articles and I am thinking of retiring within the next year and i am wondering if I should sell my house and invest in the stock market or rent it out? I live near Vancouver, BC Canada.
Thank you!
Belinda
Hi Belinda
That’s an important question that requires some more information. I’ll email you shortly so we can take the conversation offline.
First off, I love the article. I’m considering between paying down my mortgages and buying more property so I like to read these kinds of analyses.
That being said, I’m a little confused on this 19% return you’re talking about. You say that you only invested 157k but you actually invested 432k, it’s just that the bulk of it came from cashflow from the properties.
At the end of the day, your return on equity is the same: 30k cashflow / 432k equity = 6.9%.
Your return on equity is actually higher (about 10%) with all the mortgages intact, which is why leverage makes so much sense. Every time I do the analysis, it always makes sense to buy more properties vs paying them down. Maybe when I get to 9, the situation will be different.
Either way, thanks for all the articles you’ve written. I’ve enjoyed all of them very much.
Hi Nate
Thanks for reading and for the kind words.
From the nominal return on investment perspective, a leveraged investment will always produce a higher return simply because it involves a substantially reduced cash investment. However, once you adjust the return for risk, you reach a different conclusion. A portfolio of three paid off properties carries a significantly lower risk profile than one with three leveraged properties.
To clarify the confusion about the 19% return let’s take a look at what’s happened at a very basic level.
A long term rental property in our Blueprint strategy acts much like a dividend paying stock where dividends are reinvested. Your actual cash outlay into the portfolio is $157k. During the capital growth phase, positive cashflows from the properties are reinvested to accelerate the payoff of your mortgage debt. At the end of the process, without accounting for any appreciation, you own a portfolio worth $432k. In other words, you could liquidate your properties and have that amount in cash (less any closing costs/taxes etc). So essentially, you grew your capital base (which was $157k) using profits generated by the property into $432k in 12 years. Hence the 19% annual return.
But most importantly, your question leads to a much bigger trap I see most investors fall into. That is, they focus exclusively on percentage returns and not the ultimate outcome that those returns produce for the investor. If you were earning 20% per year but your capital base was $5000 that would be an impressive return but it’d still amount to $1000. Similarly, you can earn 15% cash on cash on a leveraged rental but at the end of the day, that’s still $400 a month. It’s a great return but it won’t make you wealthy or change your life. I’d rather have a 7% return on a $1.5M portfolio at retirement than a 20% return on $100k – wouldn’t you?
So my advice is to avoid a narrow focus on return percentages and start focusing on what it is that you want. How much income per year would it take to accomplish your retirement goals? How long do you have to get there? Then execute a strategy that will get you there. If you get there, who cares what the actual return was!
Thanks again for your comment.
Erion,
I appreciate your well thought-out reply!
You’re definitely right in that ultimately the percentage doesn’t really matter: it’s the end result. I think this conversation also highlights the fact that while numbers are numbers, there are still a lot of ways to interpret them!
If this were a dividend stock, then yes, your return on cost is 19% but the most important number would be the dividend yield itself (cashflow/market value). That’s the number that would let you compare investment options to decide if your money could be working harder.
If return was your ultimate goal, then an 80% leveraged investment property will produce an internal rate of return between 16-20% depending on the property. But unless you have 30 years to retirement, you will never reach critical mass unless you purchase a boatload of leveraged assets. Which in turn creates a management nightmare.
By building your capital base through aggressive debt payoff, you’re essentially foregoing current returns to reach critical mass income wise in a much shorter amount of time. Not to mention that when you in fact build your capital base, your “menu options” increase exponentially.