BawldGuy Here: I first published this post about six months ago. Many around the country have emailed me how they sent it to their buddy, their cousin, etc. I thought tonight was as good a time as any to post it again. I think it has some solid investment lessons. I hope you enjoy it.
Lost a ton in your 401k at work? Most show about 35-45% losses from their peak. Man, that hurts just to write it. Here’s a way you can very safely and prudently build a basket of retirement income without bankin’ on any appreciation.
I promise — you can do it.
Here’s an example, using real properties recently purchased by real clients. I’m gonna modify some of the numbers, but the modifications will not in any way make the bottom line better by an inch. (Worse in fact.)
What if you paid $245,000 apiece for four properties, each with an annual gross scheduled income of $28,800. The renters sign year long leases, and tend to stay a little longer than two years. We’ll set the operating expenses and vacancies at just under 40% — $10,950 a year. This results, when using currently available loans, in a negligible cash flow of less than $250 monthly — essentially a break even.
BawldGuy Axiom: Any professional analysis heavily, or even moderately reliant upon appreciation for a respectable return is suspect. Appreciation should be viewed as a luxury.
The down payment used will be 20%, though I’ll use 22% for any return figures. In these transactions you’ll be credited up to 2% of the sales price for your closing costs. The first year’s cash flow will be just under $3,000 or so for each property. We’ll assume any increases in expenses will serve to cancel out any rent increases — and yes Auntie, we’ve had rental increases lately. The loans are fixed rate, amortizing over 30 years, with a 6.5% interest rate.
If in five years the value is still $245,000 — what will you have gained? Of course, you didn’t invest to find yourself in a non-appreciating asset. Since your crystal ball is in the shop, we’ll just consider it your time in Murphy’s barrel.
So, what will put a smile on your face in this chain of events?
Income tax savings of around $7,500 a year, or $37,600 over 5 years After tax cash flow of almost $12,000 annually, or $59,800 over 5 years Principal reduction of just over $50,000 over 5 year holding period
It took about $54,000 +/- to close each of the four purchases, meaning you’ve invested a total of $216,000. In 5 years without values increasing, here’s what happened.
Add up your 5 year total for tax savings — $37,600. Your after tax cash flow for the same period is a couple hundred less than $60,000 (exclusive of tax savings). What that means to you is simple. Your Levi’s garnered just under $20,000 ($19,520) annually in spendable cash. That’s an after tax cash on cash return of roughly 9%.
You also owe about $50,000 less than the day you closed escrow. Let’s look at what you might’ve done, if the after tax income was expendable for you. The assumption is you had a generously funded Sominex Account — cash reserves — or ya wouldn’t a been my client.
If you’d taken the after tax cash flow, say $19,000 a year, and applied it monthly to your loans, your total loan balance for all four loans combined, would’ve been only about $622,000 at the end of the holding period — an equity gain of roughly $162,000. If you continued the practice ’till the loans were paid off, you would’ve gone a long way to righting your retirement income ship. The income would be, give or take, $18,000 a year apiece — before depreciation. This will take just over 16 years.
Let that sink in. If you’re 50 now and are still reeling from the cheap shot 40% loss your 401 just took, that’s really not all that long. Plus, unlike the stock market, you’re not relying one bit on the value of your investment rising even a penny from the day you bought it.
Your after tax income would run around $62,000 a year. You would’ve created this without a dime of appreciation — or a dime outa your own pocket. Not bad for only 16 years without any appreciation whatsoever, would you agree?
This is only to illustrate what’s possible for those of you wondering about your retirement. If you now have that $216,000 in capital this illustration is to demonstrate something I was taught when I first made the transition from homes to investments.
Appreciation is a luxury — period — end of sentence. If you go into every real estate investment with that axiom in mind, you’ll be changin’ the way you analyze and acquire property.
For those of you who’ve been decimated via your 401K or similar plan, this is a potential lifeline. Could things go wrong down the line? Absitively. Could those numbers be affected negatively? Yep. But they’re fairly conservative as used. Even if we reduce the ultimate end game income by over 40%, I bet you’d still like it.
If you could invest $216,000 today and end up with 36,000 in before AND after tax income, less than 60% of what would be the most likely scenario, would you be OK with that? Your original capital would’ve more than quadrupled — in less than eight years. The after tax income at that point would be over a 16% yield on the original capital — again, using only 60% the most likely scenario.
And all without any appreciation whatsoever.
Something to chew on while perusing your latest 401K statement.
Hey guys, I need a fix. Heck, I always need a fix. So call me at 619 889-7100. Have a good one.
Related posts:
- How To Quadruple Your Money With NO Appreciation
- How Can Real Estate Investors Make Money In A Local Down Market?
- Thoreau Still On The Money — Real Estate Investors? Stop Pretending
- If There’s No Appreciation the Next 5 Years, How Will You Do?
- Why Appreciation Is Most Misunderstood Real Estate Investment Concept
About BawldGuy
Jeff, I would bet 99% of real estate investors never, ever consider the discussion you just presented.
I like to refer to it as the “return on equity” discussion. The nice thing about the equity that is being created by positive cash-flow, amortization recapture, and depreciation is that the equity gained provides investors with more and more options… from paying the mortgage off, to refinancing at retirement (non-taxed event) to selling and 1031 exchanging into bigger properties.
As always… keep these great articles coming… and I believe you and I need to have a discussion about this stuff on my radio show… are you game?
Pete
Thanks so much, Peter. Let’s talk.
The observation you made about trading to bigger properties is an option most don’t even know is on their menu, because they didn’t get much if any appreciation. Nothin’ like a cool million in equity to turbo charge a retirement by way of a trade.
Jeff,
One small piece still puzzles me. Are you investing the money with a self directed IRA? IS that how you come up with all after tax income on these properties? If so, would you even be able to touch that income till your 65?
Jason
Bilgefisher — The after tax portion of the properties’ income derives from depreciation. I think where the confusion might be found is when I say this:
>Even if we reduce the ultimate end game cash flow by over 40%, I bet you’d still like it.
THEN I reduce the income of the units by 40% which would result in an approximate ‘wash’ of all ‘taxable’ cash flow, due to the ongoing depreciation. However, that was only to illustrate what would happen in a ‘Murphy’s Law’ scenario.
As I usually state, given the NOI, the purchase price, and a reasonable approach by your CPA on depreciation, about 40%, sometimes more, of your pre-tax cash flow should be sheltered.
All of it would be sheltered only in the event I used when comparing the huge Wall Street value drop to the cash flow of the duplexes.
Makin’ any sense for ya?
Jeff,
The depreciation makes sense, but don’t you have to recapture that when you sell the property? Sorry for the added questions, I just want to make sure I fully understand what your saying.
Jason
Please — never hesitate to ask any question you want.
Recapture happens in a sale, true enough. Whether or not the investor must pay it is a different story. Generally speaking, there are a couple methods by which that can be avoided.
One is by way of a tax deferred exchange. The gain along with the recapture is ‘deferred’ until such time, if ever, the investor chooses to take said gain/recapture.
The other technique is actually pretty cool. Many investors accrue ‘unused’ depreciation annually. It sits, unused, sometimes for years — growing all the time. This can be made a part of your Purposeful Plan. How? By using the ‘shelved’ depreciation to ‘offset’ taxes due at the sale of a long term investment. We just did this for a local client not long ago, erasing a capital gains tax and the rest. He took home almost $200K tax free — not tax deferred — tax free, forever.
Makin’ sense?
Jeff,
The deffered exchange makes perfect sense. Something I am looking at long term.
Ive never thought of taking the lumped depreciation all at once prior to sale. Sounds like a great idea but how is that not taken back through recapture?
Jason
It’s an IRS reg, simple as that. Please check with your tax guy. But unused depreciation will offset taxes normally due from sales of long term investments. You don’t take it before, you apply it on the that year’s tax return.
Again, please, talk with your tax guy. It’s a fun thing to do though — been there, done that.
Jeff,
Absolutely I will. Thanks for the heads up on this. I very much appreciate you taking the time to respond to my questions. Says a great deal about yourself, your business and your passion for this stuff.
Jason
Now, if it turns out to be helpful, all the better.