Friday, February 25, 2011

Why should I invest in real estate? CADA!

Why real estate?  CADA of course!  CADA is a little acronym I made up standing for cash flow, appreciation, depreciation and amortization.  The 4 main reasons allow an investor to measure their return by a numerical value!  Let's take a look at the last home I bought and consider all 4 fields...

  1. Cashflow- my most recent purchase was a $57,000.  I put $5,700 down and got a mortgage for $51,300 at 4.5% for 30 years.  The payment with taxes and insurance is $367.  A military family that I rented the home to pays me $795 a month.  So $795 - $367 = $428 in monthly positive cashflow.  That's a total of $5,136 in annual cashflow before maintenance and vacancy.  This is the greatest of all returns; therefore, it's listed first!
  2. Appreciation- I conservatively estimate that a 3 Br. 1.5 Ba in Columbia County will appreciate on average 4% per year.  With the home being bought for $57,000, it would go up in value over time by 4% per year, or $2,280.  Now an aggressive appreciation estimation would be 6-8%, considering how much money the Federal Reserve just printed we might should go with 20%, and since the home is really worth $90,00 we should multiply $90K by 4% to begin with.  However, I'm being conservative...
  3. Depreciation- We'll depreciate the value of the structure after subtracting out the land ($57K - $5,700 = $51,300) and divide by 27.5 years (view my last post if you have any questions).  This equals out to annual wear and tear on my house of $1,865.  If I am in a 25% tax bracket, this $1,865 write off would be worth $466 in tax savings per year.
  4. Amortization- When I make my $367 payment, $67 of my payment actually goes towards repayment of the principal loan amount of $51,300.  So after 1 year of payments, I'll owe $67 * 12 months = $804 less on my house!  The best part: it's my tenant paying off the loan!  So after year one, I'll only owe $50,500.  Surely this return on my investment must be accounted for because after 30 years I'll own the home with no mortgage whatsoever!  So that's an annual principal pay down of my loan in the amount of $804.
So we've now made $5,136 + $2,280 + $466 + $804 = $8,686.  Supposedly, according to the news, real estate is a terrible investment.  Yet somehow I was able to buy the above foreclosed home in today's real estate market?  With $5,700 down, $3,000 in closing costs, and a $4,000 rehab, I've achieved a 68% Cash on Cash return?  So remember CADA as you evaluate your next investment...  


  1. I think that your analysis is kind of flawed. If you are thinking of a home as an investment and a means of profit production, then the situation you describe is a pretty terrible investment.

    First of all, "buying" a home at 10% down and 30 year terms is not a simple investment, in and of itself. It is paying out cash to take on a huge debt liability: in this case a liability worth 940.5% of your actual investment. You immediate business situation upon making this "investment" is that you owe the bank almost %1000 of the cash you paid initially, as well as you owe taxes, maintenance, and insurance. Your "investment vehicle" is immediately a cash liability as well as a continuing burden on your yearly cashflow.

    So then you're in the situation of having to manage that liability, and that's where I think you get really off base. As I noted earlier you now have a cash liability worth ~($55,000), so you have two general choices. You can either sell the physical collateral immediately, or use it as a means of production. For the former you make the statement that "the house is actually worth $90k..." but that's kind of ridiculous. You can't assume that the house is worth anything more than what you paid for it. Assuming a 4% appreciation per annum is not only bullish, it is a historically bad assumption...and the likely reason you were able to buy the house in foreclosure in the first place. You have to realize that there is a massive depreciation in home values going on at the moment...something like 10%-20% of homeowners are underwater, and that figure is expected to climb in 2011, so your physical collateral that you want to sell at *not*foreclosure prices is immediately competing with a market rife with extremely low-value homes. So seeing it as a fast-profit investment is a horrible model, and likely to wind up with you, at best, in the zeroes.

  2. So your second alternative is to use the physical collateral as a means of capital production, which is what you seem to advocate most strongly in your post. You're pretty bright-eyed about your numbers, and they certainly sound positive, but again, since you're advocating this as an investment, I don't think you're looking at it correctly.

    Let's look at your numbers really quickly so that we can evaluate the costs. Loan+Interest yields a standing liability of $53,608.50 (assuming fixed rate). Additionally, you assume per annum depreciation of $1,865, so you have an additional (1865*30) $55,950, plus we'll assume that you'll need to reroof at least once in there, which I'll lowball at costing $5,000. To be really accurate you would need to factor insurance, but I can't really make an assumption, so I'll leave it out in this analysis. Anyway, for terms of your mortgage, you now have a liability worth ($53,608.50+$55,950+$5,000) -$114,558.50 before it changes from being a liability to an asset. That's now 2010% of your initial cash. So you have to find a way to reliably make the house generate over 2000% of what you paid for it initially over the course of 30 years before you even own it outright.

    Your solution to that problem is renters. Makes sense. Since renters pay per month, we'll refigure your costs a little bit. 30 year terms=360 months. Amortized, your liability represents (-$114,558.50/360) -$318.22 per month (which is a little oversimplified because some of those costs are going to be incidental, rather than monthly, but let's assume this more or less represents total COO). Now you are in the position of requiring your investment to generate at least $320/month reliably for 360 consecutive months, or risk having to source that cost from other personal revenue streams. Sure, you can probably rent it out at $750/month, but is that actually reliable? The most likely situation is that you're going to have people sign 6 month or 1 year leases. Best case scenario you have someone stay for 4 or 5 years, but that's pretty unlikely. So you have to basically sell that 30 to 60 times over the course of your mortgage term in order to generate the cashflow that you're talking about. And remember, it is only positive cashflow, not actual cash...for 30 years the bank actually owns the note on your property and could repossess it if you fail to make the payment.

  3. In order for that to be a good investment you have to assume that you have an occupied property for 360 months, you have to assume that the value will appreciate (which is not guaranteed) over the course of your terms, and you have to hope that your physical collateral continues to acts of god wipe it out or require major capital investment to repair/replace. That's kind of the lie of the mortgage/credit haven't really made a cash investment for 30 have paid to adopt a MAJOR liability, that has the potential to cost you way more than even my estimate fees/settlement if someone sues you, the cost of dealing with tenants, etc. A home is an extremely expensive property in terms of cashflow.

    THe only way that would really be a good investment is if you were able to pay cash up front for it. You can *hope* that its a good investment, but amortizing costs and using the home to generate cash is extremely risky. If you were to lose your other revenue streams and then suddenly not be able to rent this house out, you'd be in a world of $&!+ and the bank could take back your asset...regardless of how much you had already paid on it.

    So the more accurate thing to say is that a home *could* be a good investment, especially if you are able to buy it outright, but has extremely significant risks, especially to buyers without very secure personal revenue streams.