Bring the Cash Flow

Today Ramit posted a rather scathing account of his former friend Casey Serin’s real estate dealings. I have some comments on the post below:

“Wow this really made me mad. Casey had tried to sucker people into a scam real-estate deal less than a week before he admitted he was going through foreclosure.”

I agree with this point, Casey did not do well to disclose his current financial situation when attempting to gather new investors. This reeks of an attempt to use other people’s money to satisfy some of his debt. I guess he was desperate enough to try to take his friends down with him?

“I was fortunate enough to recognize his pitch as bullshit, but what if someone had gotten conned into it? Financial scams on unsuspecting people make me furious. So I read through his site. It turns out that he had bought multiple houses in different states (hoping to flip them quickly), lied on his applications to get his loans approved, and had grossly miscalculated how much it would cost to renovate and flip them. Bad move. His debt is now over $2 million.”

On this, I do not agree. What Casey is proposing in his first email is a simple scheme, not a scam. The legalities are unquestionably acceptable, however the moral implications are arguable. The scheme would involve approaching owners who are facing foreclosure and offering to buy them out of their debt obligations. The investors (Casey) would then assume the mortgage and pay the former owner somewhat less equity than they would gain in selling the house for full value. Say prospect 1 has a $150,000 home with $50,000 in equity. Buyer 1 would offer to stop the foreclosure and give Prospect1 $40,000 cash (or less… sometimes much less). Often the investor can refinance the mortgage to take most of the equity out of the house again. The house is then leased back to the former owner (because 90% of the time they don’t want to leave).

Now, secondly, Casey is not actually $2.2M in debt. Why? He bought 8 homes, so the houses have an average value of about $275,000. However, these houses have a liability of nearly 100% of the purchase price, but all of the homes are still worth probably close to 90% of the purchase price (in some cases perhaps more because he has done some renovations). So, figuring that the houses are worth 90% of their purchase price, he has $140,000 in unsecured credit card debt, Casey is actually in debt for the tune of $360,000… theoretically. A far cry from $2.2M no matter how you look at it.

At this amount of debt, I’m really not sure why Casey isn’t trying harder to unload these properties and minimize the impact. The credit card debt could likely be held for up to a year with minimal payments, now all he has to do is sell some of the houses ASAP, and try to find tennants for the rest……… is this happening?

Casey, Earth to Casey, what the hell are you doing to solve this problem?

The lever. Potentially one of mankind’s greatest inventions, no? Ken over at ARRDPD brings up a good point about making investments with little or none of your own money. (His post was in response to this one). This is of course contrary to the traditional savings scheme taught to us by our parents via their parents.

First, to address Ken’s comment, I think most PF blogs are touting the traditional ways of raising capital for retirement. Those being: you work at a job, you save your money, you invest it wisely (and usually conservatively) and then you wait. and wait. and then retire.

This is why investing in real estate is so much more interesting because you have many more options available to you. You can leverage your own money to make larger investments. You can set up a corporation like Ken has, which lends money to investors and secures it against a property. You can start an investment group where you and your partners pool their money, then leverage it through the banks and invest in larger-scale developments. Either way, you are using other people’s money to make yourself more money!

In my scheme, I’m hoping to find investors who will accept a rate of return of say 10% on their money. I’ll then pool it all, and invest in as much real estate as possible (while ensuring my return is much higher than 10% because I’ll need a safety margin to guarantee interest payments/dividends). All the money will be kept inside the company, and reinvested… thus making all of investments more and more secure over time.

NLG

Obviously there are different philosophies to generating rental income. Today, 2million blog posted an analysis of the yearly income for his rental property. His ROI is around 7%, not exactly stellar. One reason for this is that his property is not highly leveraged. Many financial advisers recommend amortizing rental properties as far into the future as possible. The reason being that any money spent on interest for rental properties is tax deductible.

The key difference between 2mil’s results and my own are that I rent to students, so I can cram 5 people into a house that would normally only have 2-3 bedrooms. Thus, my monthly rents for the house are in the $2000 range and my expenses only increase slightly due to increased utility costs. This is a major advantage to my area’s demographics (mentioned earlier).

Overall, my ROI is in the 30% range including the $$’s that flow back into the home’s equity.

I’ve recently been investigating the difference it makes to re-amortize my rental mortgages out to 25-years (they are currently slightly accelerated due to a calculation error at the bank). My payments would reduce by $60/month. If I divert this cash to my home mortgage, I’ll pay it off 2-years earlier and save $20,000 in interest (a 40% ROI when you think about it). The big advantage here is, as mentioned above, rental mortgage interest is deductible, where personal interest is not.

Thanks for sharing your results 2mil.

Well how now brown cow… I have much to learn.

ARRDPD has another interesting post that is worth writing about. This one is in regard to capitalization of a rental property. Basically, the gross income generated divided by the value of the property (similar to stock market capitalization). This is a measure I hadn’t considered yet, mostly because I was searching for properties that gave a good ROI for me. This is a similar measure, however, because my investment is a percentage of the house cost, and my income is the gross income minus expenses. However, I believe that both numbers are useful in analyzing properties as they will tell you different things (especially considering that interest expense varies month to month, thus changing ROI comparisons to prior acquisitions).

Anywho, let’s look at property #2 once more. The cap is 16%, ROI ~30%. My other property also generates a cap of 16%. The similarity is due to them both being 5-bedroom houses, rented by the room within 1km of each-other. ROI for each property does differ, however.

Cap varies significantly in my city. As you approach certain areas near the university, prices for comparable houses jump by $60k or more. One could raise rents slightly (say by 20%), but the cap would still drop to 11.7%.

However, one could also argue that these houses are still better investments than mine. Why, you ask? Because the area is somewhat nicer, the property values are higher, and because the houses are very close to the university, interested tenants are easier to find. Furthermore, if there is a downturn in the economy and enrollment drops, or more apartment buildings are built in the area around the university causing vacancy rates to raise… properties like these would ideally be easier to rent than similar properties located further away.

I am comfortable with my purchases right now. I plan to improve my properties as much as possible, making them more attractive, and because my cap and ROI are higher, I have room to lower rents and still maintain positive income/cash flow.

Anyway, enough rambling for one evening, I think.

I enjoyed this post on My 1st Million at 33.  It discusses the relative prospects of investments with different cash flow and net income positions. 

This quote was particularly interesting:

And the last important thing that many real estate investors don’t account for is calculating the cost of down payment. Some people don’t even pay attention to down payment.

Frugal brings up an interesting point here.  There is an interplay between your cash flow, net income and downpayment.  For instance, on the previously mentioned Property #2, our downpayment was 25%.  So, although the property provides a cash flow of $12,000, we will not recover our initial investment for about 3 years.  This is a ROI around 30%.  Now, if the housing market happens to turn downward, things will look much different.  Say the property value drops $10k over one year, we effectively earn nothing in that year because of the loss in value.  Thus, your actual position will not be reflected in either cash flow or net income.  This will actually be reflected on the Balance Sheet.

So, for now, our net income is $12k/yr, our ROI being 30%, and our break-even is in 3-years at which point the house price could fall 25% and we would not lose any money overall.  According to what I’ve read, this will hopefully not happen.  My market is not as overvalued as many markets in North America, and I’m hoping that if there is a correction, it will take a couple of years to pan out.

Furthermore, one must also include any closing costs in their calculations.  These are out-of-pocket expenses that cannot be reclaimed by selling the house.  In fact, selling will of course generate more unrecoverable costs.

The previously mentioned software package SolveIT! does a good job of working out all these costs and showing you when your property will fully pay for itself and generate new income (other than the downpayment).  It includes tax benefits, selling costs, appreciation and inflation.  Based on my numbers, I will have paid myself back for the downpayment in 2008.  After that, assuming no housing market collapse, the net income goes into my pocket, and my equity continues to build.  Assuming 1% price inflation, if I sell after 18 years I should net a total cumulative income of $241,800…. 

but this is all speculation, fun though it may be.

Tags: Real+Estate, Income

Tags: Real+Estate, Income