The Window of Cheap Money is Closing

Tonight it's time for me to predict the future.  In Ben Bernanke's latest remarks, the fed chair indicated that on June 30, 2011, the Federal Reserve will stop buying all these mortgages.  What does this mean?  When you go to get a mortgage, the mortgage is sold by the bank to the secondary market where it is securitized and sold to investors.  The federal government has been buying a ton of this paper, the amounts are in the billions and trillions.  On June 30, they will stop buying all this paper and regular investors are going to have to fill in the gap of 50% of the mortgage market. 

So mortgage rates will go much higher because investors who invest in mortgages like your home mortgage aren't going to be content with a 4%-5% return, especially not with the raging inflation we're seeing right now (have you been to the pump lately?).  I paid $4 for a gallon of milk the other day...come on man.

So how high are they going to go?  I'm pretty bullish on mortgage rates skyrocketing (I don't want them to one bit of course).  But I see rates going up drastically!  Maybe 2-3% by the end of 2011.  I think we are eventually headed to a situation that the US was in during the early 80's.  This means interest rates of 20%+! 

What does this mean for you?  If you have an ARM, you are toast.  Refinance NOW to a fixed rate.  Adjustable rate mortgages shift ALL the risk of rising rates from the bank to you; and all for what?  0.5% less on your rate?  This is negated the moment the rates rise and we know they will.  When all the bailout money trickles down and the inflation starts being felt on the streets, the Fed will only be able to raise rates to fight inflation.  It's their only tool left.  Plus, even if your ARM has a ceiling, as soon as you hit your 3, 5, or 7 year balloon, what will you do?  What's your plan then?  Refinance?  Probably not since rates will be 10%+.  Sell?  Do you want to be forced to sell?  Foreclosure?  Not fun.

What if you already have a fixed rate mortgage?  Great.  Stick with it.  Now would be a good time to borrow money to buy rental properties as well.  For every mortgage in your portfolio at 4.5% - 6%, when inflation hits, your assets will skyrocket in value (not price) and as rents appreciate, your fixed rate mortgage and payment will stay the same. 

Let me know your thoughts...

Cashflow: The Foundation of Investing

Last week we learned about CADA, the 4 advantages of investing in real estate.  We've covered the D, depreciation.  Now it's time to cover the C, Cashflow. 

Cashflow is the first letter in the acronym because it provides the foundation of the investment.  If you don't have your home rented, you will inevitably pay the mortgage yourself or be foreclosed on.  So that's why it is so important to know what your rent and mortgage prior to making offers on homes.

Here's the simple formula for cashflow: Rent - Mortgage = Cashflow.  Simple, right?  You take in the rent by the fifth, pay the mortgage by the 16th, and what you have left is your cashflow.  Store some money aside for maintenance as well as vacancy and you are good to go.  Let's go into each variable of the formula...

Rent- find out what a property will rent for before you make the offer!  How, you ask?  Ask your real estate agent, ask property management companies, compare it to homes that you already own that are rented, and best of all...pay attention to this...drive every street of the subdivision and call all the "For Rent" signs you see to find out current market rents.  Won't these other homes be your competition once you've bought and rehabbed your home?  I do this every time; guaranteed.

Mortgage- your mortgage payment is normally composed of 4 things: principal and interest (based off your loan amount, interest rate, and terms), taxes, and insurance.  How do you figure out what this will be prior to buying a home?  To find out principal and interest, google "Financial Calculator," or get an app to do it for you.  My favorite app is "CalcsFree."  Find out the taxes from the county website (http://augustaga.gov/) or http://www.zillow.com/.  Insurance?  Just call your insurance company and have them give you a quote or compare it to your personal residence and guesstimate. 

So here's an example of how to calculate cashflow that I did on a real live home that I made an offer on recently: Rent- $1050.  (I have one comp @ $1095 that I've seen...).  Mortgage- $100K @ 5% over 30 years = $536.  Taxes + Insurance = $164 / mt.  Total Cashflow is $1050 - $700 = $350.  $350 is an excellent cashflow because you're making $4200 / year before maintenance and vacancy expenses.  A good rule of thumb in today's market is to use a debt service ratio (http://en.wikipedia.org/wiki/Debt_service_ratio) or 1.4  So if your rent divided by mortgage is > 1.4, it's a solid deal.

A good quote from some of my favorite authors, the Real Estate Guys (http://realestateguysradio.com/), "Cashflow controls mortgages; mortgages control properties!"  So keep the cash flowing your way and have fun investing!

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...  

A Straight-Line Depreciation Schedule

Since it's tax time, I wanted to give you a simple explanation for what may seem like a complicated topic.  Depreciation is the IRS's definition for real estate incurring wear and tear as time goes on; in fact, for tax purposes, the IRS allows you to assume that your real estate will be totally worn down and useless after 27.5 years for residential investment property.  Here's how you calculate depreciation:

If you buy a home for $100,000, subtract out the value for the land since even the IRS knows that dirt doesn't wear out.  A liberal valuation for land would be 10% of the purchase price.  So $100,000 - $10,000 = $90,000.  So we're depreciating $90,000 over 27.5 years, this would be as follows: $90,000 / 27.5 years = $3,272 / year.  This amount you can write off as a deduction against the cashflow of your home, essentially allowing that income to be tax-free.  So if you have a home and you earn $200 / month positive cashflow, or $2,400 per year, you can not pay tax because you have $2,400 in income, with a loss of $3,272 in wear and tear.  So $2,400 - $3,272 = -$872.  Guess what?  You can now take the remainder of this "loss" against your personal earned income from you JOB!  So now you just sheltered $2400 in rental income, plus $872 in earned income, and you didn't even have to spend the $3,272 to get the write-off because depreciation is a NON-CASH EXPENSE!!!

Now imagine if you had 5 homes depreciating at $3,000 per year...imagine if you had 20?  Would you pay any income tax on your earned income?  Would the government actually have to write YOU a check in your depreciation exceeded your earned income!?

Any questions?