investment

Is That Investment Profitable?

April 29, 2011 By Jon Griffith Leave a Comment

I was poking through some of the properties in the Historic Phoenix Districts and I came across one that caught my attention, much like it would many people.

Aside from owning your primary residence free and clear and reaping the increasing valuation over time, there are two ways that I can think of off the top of my head in which you can invest in a single family home. In both instances, the purchase price of the home determines the ultimate return on your investment.

Method 1 – The Flip

The goal in the flip is fast turnaround. You need to know what to buy, where to buy it, when to buy it, for how much, and the cost of reconditioning. You also need a lot of cash on hand. It’s a venture that requires that you spend time doing your due diligence to ensure that when you sell the house, you actually make money. Don’t be too quick to purchase a $40,000 home thinking you can turn around and sell it for $140,000 (it’s happened dozens of times in the Coronado District) and walk away with $100,000 in pure profit. You’ll be spending quite a bit of money and time reconditioning, remodeling, and marketing the property. Sales commissions alone could run you nearly $10,000, and you’ll need to have a great team of contractors who do honest, quick work at a fair price.

Method 2 – The Rental

This is my preferred method. My real estate philosophy is to own as many paid-for homes as possible to generate passive income, and increased property value over time.

The rental is also a tricky beast. One might think the following:

“I’ll buy a house that needs minor repair for $50,000. I’ll put $10,000 into repairs, and then rent it for $600.00/month.”

Obviously location is going to play a part in how much you can charge for rent. Now, let’s make a mistake in calculation. Based on the above numbers, I could make the mistake of dividing my total cost ($60,000) by the monthly rent ($600.00). If I do this, logic would tell me that it will take 100 months, or 8.3 years to get my $60,000 back.

That’s nice, but not true, because we’re working with something called “Net Operating Income” which is what you’re left with after you pay your expenses, which you MUST consider before you go crazy buying that property.

So what are the operating expenses?

If you pay cash for the property, your expenses will be less, and you’ll also be able to choose your tenants wisely, because you won’t make desperate decisions under the pressure of a mortgage payment.

The First Expense will be property taxes. When you own your house free and clear, you still have to pay annual property taxes. They are never the same year after year, and as the value of the house goes up, so does the tax bill. I’ve looked up the tax bill on a property in Phoenix with an approximate value of $50,000, and the total for the year is about $1090, give or take.

The Second Expense we’ll take into account, is property insurance. We must insure the home. We don’t insure the tenant’s belongings, we only insure the home for the cost to rebuild it. In our current market, we can buy homes for less than it costs to build them, so determining this number is going to be dependent upon a long interview with your insurance company, and it will be affected by your credit profile, as insurance companies definitely take this into account. Let’s say, for gits and shiggles, that your annual insurance bill is $350.00 for $100,000 in coverage.

The Third Expense you’ll need to consider is your annual repair bill. If you think you can get away with renting your house out without expected repairs and deferred maintenance, then you’re delusional. You WILL have repairs. A roof WILL need to be replaced. A water heater WILL go out. Set aside 10% of your annual rental income to cover expenses. That’s $720.00. It may be conservative, but I feel better that way. One would rather err on the side of safe, than not. If it’s not all spent, put the difference in a reserve account and save it for larger repairs and emergencies. I don’t typically endorse a home warranty, but if you want to calculate it into your expenses, add $350 per year. That rounds out to $1070. With a warranty, the annual repair bill could be lower, as some of the repairs will be covered by the warranty.

Quick recap. We’ve racked up 3 expenses now:

Taxes – $1090 +/- per year.
Insurance – $350 +/- per year.
Repairs – let’s call it $1000.00.

On to the rest…

The Fourth Expense will be the vacancy rate and it will vary depending on the health of the rental market and the location of the property, condition of the neighborhood, etc. Vacancy must be calculated because you WILL have months in which you have no tenants. Calculate 5 to 10 percent of the annual gross rental income. In this case it will be $360 – $720 per year. This may not become a realized expense, or it may be larger one year over another. It truly depends on the performance of your rental.

The Fifth Expense will be property management. If you choose to have a property management company handle the acquisition of tenants, collection of payments, and facilitation of repairs, you can expect to pay somewhere in the area of 10% of your gross rental income. That’s another $720 per year.

So lets do the math on all of these costs:

Income – $600/month = $7200.00/year.

Expenses (annual)

Taxes – $1090
Insurance $350
Repairs – $1000
Vacancy – $720 on the high side.
Property Management – $720+

Total annual expenses: $3880.00 +/-

Are you starting to see how this works? And these are very rough estimates. So how do we calculate a) the amount of net operating income we’ll have at the end of the first year, b) the time it will take to recover our initial investment, and c) the annual return as a percentage.

The NOI (Net Operating Income)

Simply subtract from the gross rental income ($7200.00) the annual expenses ($3,880.00) and you’re left with $3,320.00.

The Time It Will Take to Recover the Initial Investment

Divide your initial investment by your NOI. $60,000 divided by $3,320 = 18 years.

The Annual Rate of Return

Divide your NOI by the total investment. $3,320 divided by $60,000 = 5.53%, not including increased property value.

As you can see, what appeared to be a really cheap way to get into the market to invest in a rental could suddenly not be worth the time and effort. You could cut corners to maximize your annual return, but that may come at a greater cost to you in other frustrating areas, like having to market the rental yourself, deal with bad tenants, evictions, etc. Blech!

The real value I hope that you take away from this article is how important it is to do your research before pulling the trigger on that real estate investment, or any other investment. It’s never a good idea to get into something until you know exactly what it is that you’re getting yourself into, and as you can see, there are many factors to consider.

I’m not discouraging you from investing in rental properties, as it is a fantastic long term solution to building long term wealth. In fact, after 18 years, you may have a house that’s worth $100,000 generating $3,320 in passive income every year, but if you really think about it, $100,000 in value returning only 3.32% annually isn’t such a great investment. You’d want to keep hunting for something better.

For instance, if the original cost of the home was only $30,000 (and they exist), you recoup your cash in 9 years and your rate of return is now 11%. Much better. Or if your $60,000 home had a rental rate of $900.00/month, then your NOI would increase from $3,320 to $7,420 yielding an 8 year return at 12.3%.

Over all, the original scenario isn’t that great. You’d probably be better of putting $60,000 in a growth stock mutual fund for 18 years at an average of 8-10% per year. At the end of 18 years of compounding growth you’d have about $650,000 – $1,200,000 socked away. There aren’t many, if any $600.00 rentals that will appreciate from $60,000 to $650,000 in 18 years.

Filed Under: Buying A Home, Real Estate Finances Tagged With: house, investment, property, rental

The Debate Continues: One User’s Opinion on Renting vs. Buying

September 23, 2009 By Jon Griffith Leave a Comment

As with anything, there are pros and cons that change with every complicated variable involved. The concept of buying being better than renting is relative to the context of each side of the equation at any given time. No two situations are the same, but generally speaking, assuming certain conditions are already met, owning a home is MUCH BETTER for long term wealth building than renting.

In an article that I wrote back in 2008 on the SonoranHouse.com blog, I illustrated the financial benefits of renting vs. buying. Here’s what one user had to say, along with my thoughts on the response:

WRONG… Renting is FAR better and Cheaper than buying a house.

Not so fast. There are too many variables involved, and each situation is different, but the principle cannot be disputed. Owning is a long term prospect. Not short term. In order to conclude that owning is better, one must assume that the property will be held for as long as possible.

1. The down payment is $20,000 OUT OF YOUR POCKET on day one. SO by purchasing a house you are immediately $20,000 POORER the day you buy your house. In contrast, you can RENT and only pay a SMALL deposit equal to 1 months rent and keep the rest of your $19,000 to use as a safety net to pay the rent with and live an easy STRESS FREE life knowing you have the rent covered for 19 months if it’s a $1K a month rental.

When you pay a deposit to a landlord, it is a fee that can never be recovered. When you put money down on a house, you are instantly investing your hard-earned cash in an appreciating asset. You are not spending the money. Again, if your investment mindset is short term and you sell your home too quickly, you will certainly cut into your initial down-payment unless your property experiences unheard of appreciation in a short time period. Not likely to happen again. Buying real estate is a long term wealth building investment.

A rule of thumb for an emergency fund is 3 to 6 months worth of living expenses. If your rent is $1000.00/month, you have 19 months of rent paid for, but that doesn’t take into account the rest of your expenses. If a down payment on a house depletes your living expenses, they you are not ready to buy. Your down payment should be above and beyond your 3 to 6 months. So, if your expenses are $2000/month, you should sock away about $12,000. The rest can be used towards your future down payment. This all assumes that you are completely out of debt. If you aren’t, then you shouldn’t be buying a house in the first place. Most renters do not have this much money saved up and they live paycheck to paycheck, so they feel they NEED to have some sort of financial buffer to buy them time.

The problem with this is that they never get OUT of the rat race by behaving this way, and they never put their money to work for them. They will live the rest of their lives working for their money. What would be the difference between having 19 months of STRESS FREE living in a home that is appreciating in value versus apartment living with the same amount of a safety net? The difference is that part of your monthly payment is being added to the home’s equity. Some of that payment will be recovered. NONE of the rent will.

2. The Tax Deduction is nonsense… You spend $1.00 in Mortgage Interest to deduct .10 cents off your tax bill. HARDLY a “savings” at all. Your still LOOSING .90 CENTS in interest!! WAKE UP PEOPLE!!

Tax Deductions are a poor excuse for people who are poor to continue to be poor. The argument here is that it makes sense to pay the bank $1.00 in interest to avoid paying the government ten cents. Obviously that is flawed thinking. Spending 90 cents to save 10 is absolutely ridiculous. That is why the largest mortgage anyone should be financing is a 15-Year fixed. Obviously paying cash is the best way to buy a house.

3. When you own a house you pay PROPERTY TAXES each and every year. These taxes are about 1.5% of the value of your home or around $3000 a year. That’s $3K a year your LOOSING if you own a house.

Hmmm…let’s see. Property taxes at $3000/annually, deductible at your tax bracket rate, or $12,000 wasted on rent. Personally, I’d rather put the remaining $9,000 in growth stock mutual funds to offset the perceived loss, because by the time my $9,000 per year is invested over 30 years, it will pay the property taxes a few thousand times over.

4. When you own a house you pay Property INSURANCE on your house each year. This will be about 1% of the value of the home so figure $2000 a year on a $200K house.

I own a $200K home. Taxes and insurance annually do not exceed $3000.00. In fact, they don’t exceed $2000.00. This has everything to do with location and tax rates. Again, I’d rather cough up $2000/year for insurance than blow $12,000/year on rent. So based on points 3 and 4, which add up to $5000.00, I’m still ahead with $7,000 invested annually in growth stock mutual funds. Come to think of it, my down payment of $19,000 as used in this example will be reimbursed fairly quickly.

5. When you own a house you pay for ALL MAINTENANCE/REPAIRS/REMODELS. This means spending about 1.5% of the value of your home EACH YEAR to keep it in livable condition so figure another $3000 a year on maintenance/upkeep.

Nobody forces remodeling, so we’re going to remove that from the equation. Deferred maintenance is a price that everyone has to pay for, whether you own, or you rent. As the king of your castle, you determine what’s used on your property to improve and maintain it and you have a choice over the cost/savings realized from it. By renting, you have no control over these things, and the cost of rent is at the discretion of the landlord, who can easily raise it high enough to force you out to make room for someone else as a result of increased management costs. Owning your own home offers greater long-term housing security.

6. In order to “get your money back” out of your house you will need to SELL your house. This means FINDING SOMEONE ELSE TO BUY IT. You’ll have to pay Closing Cost, Real Estate fees, etc. and it can take a LONG TIME to find a buyer. THEN even if you sell, you will have to live somewhere so you would have to turn around and buy ANOTHER house or do what most smart people do in the first place… RENT.

False. As a long term investment, the asset appreciates and the value of the loan decreases over time. If you paid cash, you have an instant money making machine creating passive income. If you didn’t, you’ll eventually reach a point at which renting your home to someone else will generate positive income above what you owe on the mortgage payment. The tone of point number six seems to emphasize the dependence upon cash in the bank to provide a safety net. Obviously if you’ve been able to save $19,000, you’re making more than you’re spending, so the time that it takes to sell should be irrelevant unless you’re forced to move via relocation or other circumstance beyond your control. It’s true that if you sell too early, you’ll erase your gains because you didn’t have a long term mentality. There is so much more risk to buying a home when you borrow, but if you are able to pay cash for a home, then I’d say you’re living well financially. One’s intelligence is not a factor determined by the decision to rent or buy. One’s wealth, however, is. If you want to get rich and live free like nobody else, then you’ll invest wisely. Renting is not investing.

Owning a house ONLY makes sense IF you could pay CASH for it. Even then, your still going to “Throw money away” on Taxes, Insurance, Maintenance, and the excess bills that come from owning a house when if you RENTED many of those bills are included in the rent.

Paying cash for a home ISN’T THE ONLY time it makes sense to buy a home. It is the BEST practice for sure, but you’re not throwing money away on taxes because your home is appreciating in value, and in theory, you’re renting that home out, collecting $1000.00/month rather than spending it. Can you imagine how nice it would be to be able to put $12,000.00 less a few expenses every year without having to work for it?

The fact that there are additional bills when you own versus renting is also a false assumption. Do the math over a long period of time. Take the appreciation of real estate and the potential passive income from owning a rental and see where it would be in 30 years if invested wisely, long term. Compare it to the real costs of owning. Remember, we’re talking about ownership versus renting. We’re not talking about owning a high cost property that has no potential to generate future income. That would not be a wise investment. Of course, you could just keep on throwing your hard-earned money away. In fact…

…I’ll look forward to renting one of my properties to you because you sound like the perfect tenant.

Filed Under: Personal Finances, Real Estate Basics Tagged With: appreciation, Buying A Home, equity, investment, ownership, Renting, Rich, wealth

What To Do In Uncertain Times Like These

September 27, 2008 By Jon Griffith 1 Comment

Turmoil. That may be the first word you think of when you hear the word economy. Believe me, I hear it and feel it every day too! With talks of bank failures, bail-outs, stock values, election campaigns…whirrrrrrrrrrr BANG! That’s what happens inside my little brain. I tend to want to shut down and ship out.

Here’s the problem we face. Most of the time we act in haste on feelings and forget that the feelings are a result of something that has already happened. It’s at this point when we face the most difficult challenge of choosing the best response to our fear, anger and sadness. In times where things seem desperate, or uncertain, remember not to react in an unhealthy and damaging way. Take inventory and make a healthy, rational decision about what you’re going to do.

I recently created a poll on my website, www.RealScottsdaleLiving.com which asks you whether or not you believe that the United States is headed for a 2nd Great Depression. Of 18 votes in the past 12 hours, 16 people’s opinions indicate that we are. I’d love to know what you think about these economic times.

What about the banks? Ahh yes, what about the banks…

The American Bankers Association says that most banks who are considered to be in trouble return to profitability without intervention, and you won’t know about it, so you won’t know if your bank is going to fail. So let’s say your bank does fail…does that mean that you won’t have access to your money? That depends. If nobody buys your bank’s assets and deposits, and/or there’s no new company formed to handle the funds (usually occurs between Friday and Monday) then your money would not be accessible. If your bank is purchased, then you most likely would not see an interruption of service. If your funds are not accessible, on the Monday following the failure, the FDIC would begin to send you checks in the amount of your deposits.

What about the stock market?

This is where the impulsive selling could plunge you into a panic causing you to pull the trigger and sell. If you’re financially independent and you’re not still working towards building your life’s nest egg, then you can get out of the market. Most of us are not there yet, and the stock market has proven to be the highest return on investment over the long haul than any other investment vehicle. Stick with it and don’t sell off just because you’re afraid of losing. Remember, you don’t actually lose your money in the stock market until you sell. If you’re concerned about a particular company, do your homework and move your funds somewhere else.

What about real estate?

Well, they aren’t building any more land. The Earth has only so much of it, and since we are creatures who crave community, it’s not likely that you’ll be interested in purchasing a plot of land in the middle of nowhere unless you like that sort of thing. Property also goes up over the long haul, and with interest rates as low as they are, and thousands of short sales and foreclosures saturating the market, as a buyer, you are in a position to reap a huge reward down the road. My advice to you, if you have money sitting around doing little or nothing, is to buy a house.

There’s no crystal ball in any economy. All we have are patterns of the past, and the patterns show that we grow, consistently, without fail. We are getting smarter, more innovative, and there are more of us. The economy has nowhere else to go but grow. The question for you is whether or not you’re patient enough to let it happen.

Filed Under: Blah Blah Economy Tagged With: Bankers, economy, election, fear, haste, investment, market, profitability, Turmoil

It’s a Gamble that Freddie Mac

September 24, 2008 By Jon Griffith 2 Comments

On the 16th of September, Freddie Mac hit an all time low of 25.9 cents. Wow…just imagine, you could have purchased 1000 shares for $259.00.

Today, in afterhours trading, Freddie Mac is currently going for $2.04. Your little $259.00 investment on the 16th would now be worth $2040.00.

There’s really no point in looking back on events like this other than to dream about what could have been, which is living in regret. Do you have an opinion about the market conditions? Leave a comment today!

Filed Under: Blah Blah Economy Tagged With: Freddie, Gamble, investment, Mac, market, September, trading

To The Owner, It’s More About the Home

September 24, 2008 By Jon Griffith Leave a Comment

There’s nothing worse than media articles that continually pound the idea that your finances are in shambles. YOUR finances. I’m not certain what the analysts in the stock market are attempting to convey during these strangely unique economic times other than:

You’re going to lose your job soon.
Your interest rates are going to increase.
You should not by a house.
The world as we know it is gone forever.

ENOUGH ALREADY!

An article posted today at Marketwatch.com states that…

The purchase of a house is the ultimate confidence indicator, and if there’s anyone out there with any confidence these days after what the markets and the financial sector have been through, then you’re talking about the true eternal optimist.

Are you that optimist? Are you someone who wants to “indicate confidence?” We in the real estate business know the value of home ownership. We understand that when you buy a home, you put part of your payment into the value of the house, and part of it goes to the bank. When you rent, which is what many people who are sitting on the fence are doing, all of your payment goes to the owner of the home, and none of it is invested. Furthermore, none of your payment will help you reduce your tax liability at the end of the year. And historically over time, your home will increase in value.

Are you interested in giving yourself a raise? Then buy a house.

the housing market looks like a sunken soufflé

What a way to make a soufflé unappetizing. But we’re not talking about food are we. We’re talking about the concept of buying low and selling high, and the only thing that sunken represents to me is a low point, which is when I would buy. What about falling prices? When buyers hold out, sellers drop their price. That’s just basic supply and demand.

But why, ultimately, are you thinking about buying a home? Is it purely financial? I would hope not. This “sunken soufflé” could give you a perfect opportunity to finally secure a home. Not a house, not an investment for quick profit, but a home. Somewhere you can relax and entertain. Somewhere you can raise your children over the next 10 years. What you need is a place to call home.

If you look at the market in this light, it makes perfect sense to buy a home. Real estate is and always has been a long term wealth building investment vehicle, but more than that, it’s your little piece of America that you can rest upon every night when you come home from a long day at work.