Lee Smith’s Indianapolis Real Estate News and Views

Lee’s Notes: Good post from Vena Jones-Cox..

Is it Every OK to Pay Full Price for Real Estate?
Here’s an idea that’s gone out of fashion: building humongous wealth in real estate is a long-term process.

I know, I know…wholesaling, retailing, buying and selling creatively-they all hold the promise of quick cash. That’s why sales of courses and bootcamps on these topics will continue to outstrip those of courses on long-term buy-and-hold strategies by a margin of 100 to 1.

But let’s face it, not everyone is cut out to do the wheeling and dealing that these strategies require. Each and every one of them requires the investor to sift through dozens of potential leads to find the one deal where the seller is desperate enough to take 70 cents on the dollar for a quick sale, or is open to creative finance deals that are way outside of the average American’s frame of reference and comfort zone. In other words, the investor has to be both willing and able to negotiate a price and/or terms that make the deal work for him-and find a seller for whom the terms work as well.

Furthermore, depending on the strategy, the investor (let’s just call him “you” from now on) has to have the time (and in some cases, skills) to make the deal make money after the purchase. In the case of a retail deal, the low purchase price does not automatically equal a high profit-cost overruns, holding expenses, poor neighborhood selection, and unexpected repairs can quickly eat up any potential gain. In many creative buy/sell deals, as little as one month a year in vacancy can kill the profits for the entire year.

Now, don’t get me wrong-I am a big fan of (and practitioner of!) these short and medium-term deals. Like most full-time investors, I depend on them to take care of immediate cash needs, build money for long-term holds, and, frankly, to keep food on the table. But the source of my wealth-and that of every other real estate investor in the country-is the tax breaks, appreciation, and mortgage pay-down that comes from owning rental properties.

And what’s more, quick-turn deals just don’t fit into everyone’s lifestyle. Many people are just downright uncomfortable with the negotiation factor; others are unwilling or unable to commit the time it takes to deal with dozens of sellers for each property they buy; still others are in a tax situation that makes any type of short-term capital gain a major tax burden. And a mega-profitable quick-turn business requires a lot of volume-1,2, or even 10 deals a year aren’t going to make anyone a millionaire, especially since the profits are ultimately taken out in cash which, let’s face it, we tend to spend rather than grow into more profits. And doing more than 10 deals a year is difficult for anyone who plans to keep their “day job” for whatever reason.

So what if there was a way to become a millionaire in real estate without hard-ball negotiation, without a full-time commitment, and without making dozens of offers for each deal you buy? What if, in short, you want to be a completely hands-off, passive real estate investor?

There is-but in order to do it, you have to be willing to go against all of the training you have that says that smart investors don’t pay full price for properties. Oh, and you may have to consider investing outside of your own geographical region. Wanna hear about it anyway? Here goes.

When and Where to Consider Paying Full Price

First, some background for readers who live on certain parts of the east and west coast, Arizona, and Florida.

In most of the United States, it’s possible to purchase single and multi-family rental properties in decent areas for full price, pay 20% down or less, and still have positive cash flow at current interest rates.

This rule primarily applies to properties with an after-repaired value of 120% or less of the median house price in the area, and becomes MORE true as you move DOWN the scale. For instance, in Cincinnati, the median house price is around $125,000; a home with an ARV of $170,000 will rent for about $1400 a month and have positive cash flow if the mortgage is 80% of value, or $136,000

On the other hand, a home with an ARV of $70,000-which will be in an almost all-rental neighborhood-will rent for about $800 and will have a cash flow of $200 or so with $56,000 mortgage at 6 %.

A $50,000 property-which will be a high-demand rental, but almost certainly in a “border zone”, will rent for $700 a month and have a $300+ positive cash flow if mortgaged at 80% of value.

The trade-off, of course, is that the $170,000 will appreciate a LOT more and have a LOT more tax benefits than the $50,000. And needless to say, there are factors other than the mortgage payment that must be considered; in cities with very high property taxes or additional fees for garbage collection or landlord licensing, the numbers clearly change. But on the whole, here in flyover country, it’s possible to break even-or even make money-paying full price for a property and financing it conventionally.

So what’s so exciting about breaking even?

Well, not much-IF your goal is to live off the cash flow from the property today. But remember, for the vast majority of people looking at investment real estate, cash flow now is not as important as cash flow later, wealth-building, and, most importantly, ease.

Even full time investors like me aren’t generally looking to their rental properties for immediate income; instead, I’m looking at my rentals as a retirement fund that have no impact on my income right now, but have a major impact on my TAX situation right now. My income-the putting-the-food-on-the-table money-comes from my short term, highly taxable wholesale and lease/option deals. My wealth-the retiring-young-and-traveling-the-world money-comes from rentals. And in the meantime, I want to be able to focus my time and energy on my high-profit, quick-cash strategies, and have someone else worry about filling and managing my rental homes.

So in order to evaluate the REAL benefits of paying full price (or close to full price) for we have to look at the long-term impact of owning the property. And this means evaluating the tax implications (which affect your income immediately) and the growth implications (which affect your future) of owning rentals.

The Tax Benefits. The IRS allows owners of single family investment properties to “depreciate” the property over time. In other words, for tax purposes, the home is treated as if it were “wearing out” and decreasing in value each year, instead of growing in value.

Single family homes are depreciated over 27 1/2 years, and a conservative accountant will tell you to set a “basis” on your property of 80% of your purchase price. The resulting number is then deducted from your net income from the property. And if THAT number is a negative number-which it almost always is in the first 5 years you own the property-that “loss” can flow over and shield your ordinary income, as well.

A paper loss of $1,000 a year equates to a tax savings of $150 in a 15% tax bracket, $300 in a 30% tax bracket, and so on. Although the tax breaks are something most people think of only on April 15th, they are a real, quantifiable addition to your yearly income, and must be taken into account when looking at the overall profit from the property.

Long-term appreciation. Another benefit of owning properties for the long haul is the growth of value of the property over time. Although the appreciation in the last 3 years has been NEGATIVE, all this means is that by paying full price, you’re buying at or close to the bottom of the market, and are positioned to get the appreciation that will be driven by the recovery of house prices.

If you use 3% as an extremely conservative estimate of yearly appreciation, over the next 5 years, a house worth $150,000 today will be worth $168,000 in 5 years-an untaxable, unspendable, but very real profit of $18,000.

Equity Paydown. At the same time that the property is increasing in value, the loan amount is decreasing thanks to the efforts of the tenants to pay it off for me. As you know if you’ve ever looked at the amortization schedule of a 30 year loan, this takes place slowly at first and accelerates as time goes by.

Nonetheless, in our example of the $150,000 bought with 20% down at 6% interest, the tenant pays off $1,473 of my loan in the first year-another real, untaxable profit center. Of course, this number gets bigger each year as principal payoff accelerates, but even in the very first year, it affects your overall return.

So, sometimes, for some people, in some situations, paying full price for investment real estate is a smart move. But before you run out and do this, let’s talk about what it takes to make it work in the real world. No matter what your financial situation, do NOT contemplate this strategy unless:

The property is fully renovated when you buy it. Obviously, it doesn’t make sense to purchase a home for full retail price if it needs work to bring it up to full retail value. But it also doesn’t make sense to pay full retail less the actual rehab costs for properties that need repairs. The whole attraction of this technique is that it is relatively hands-off; if you’re going to do work to a property, you can and should be paid for the time, money, and energy you put into repairing it. And since the idea is that you’ll be paying close to full price anyway, it just makes sense to buy something that won’t need a roof, an electrical update, plumbing, etc. in the near future.

The property has at least break-even cash flow, NOT including the effects of appreciation, tax savings, and equity paydown. The only time it makes sense to buy rental properties that have significant negative cash flow is when the same property has very large appreciation potential-and expecting a property to appreciate 10-20% a year in today’s slowing market is speculation at its worst.

Incidentally, if you’ve never owned rental property, you may not be aware that “break even” cash flow, in the real world, means negative cash flow in some years and positive cash flow in other years, evening itself out over the long term. If you live in a market where it’s impossible to buy a decent house in a decent area with break even cash flow, you may have to consider buying a package of properties in another region of the country and having them managed to make this work for you. Remember, the idea here is long-term growth with minimal hassle, NOT to get rich in 5 years from high appreciation, and NOT to spend your own money “feeding” your rentals year after year after year.

You’re qualified for the financing that makes this work. In theory, when you buy a property that breaks even in year 1, it should be cash flowing by year 5 and cash flowing strongly by year 10 due to rent increases.

However, this scenario really only works with a fixed-rate, low interest loan. It’s a fact of life that our mortgage interest rates will be increasing in the foreseeable future, and it’s also the case the rent increases normally lag interest rate increases.

If you can’t put 20% down, or can’t qualify for a low fixed-rate 30 year loan, it just flat won’t work.

You can leave your money invested in the property. Since this entire scenario is based on long-term growth and mortgage paydown, it’s crucial that you have the ability MAKE a downpayment, and then LEAVE it in the property (I know, I know, there are gurus all over the U.S. who would be rolling over in their graves right now, were they dead). But if you refinance the property at any point to pull out cash, you’ll not only decrease your cash flow a that point in time, you’ll also set yourself back years in terms of the mortgage paydown. Investing this way is like buying stock-you should be in it for the long haul, or not at all.

You are absolutely certain that the property will be well-managed. The success of this strategy-both long-term and short-term-hinges on good management. Whether you plan to self-manage or hire a property manager, your razor-thin cash flow margins depend on keeping the property rented, keeping the tenants happy, and collecting every dime you’re owed.

The 20% expense allowance in the examples assumes that you DON’T put a tenant in your property that’s going to do major damage to your property, and that you DON’T lose out on months of rent each year through vacancy, non-collection of rent, or lengthy rehab periods between tenants. If you can’t run your rental business like a true business, hire a good, competent property manager who will.

A note: if you’re going to hire a manager, talk to your tax professional first to make sure you won’t be subject to passive loss limitations in your tax write-offs.

Buying rentals at full price certainly doesn’t give you the “rush” that some of the other strategies available in real estate do. But real estate is such an important part of every financial portfolio that if you aren’t ready or aren’t able to do what it takes to wheel and deal in the real estate world, it’s sure better than doing nothing at all. For the right people in the right situations, it’s the obvious alternative to waiting to start a real estate career.