Before I start bashing equity thinking, I have a little confession to make: I still own the first home I purchased. It makes no sense as a cash flow investment, but it’s the only emotional property I own, and I’m in a position that allows me to keep it even though the equity on it isn’t working hard at all. I’m fine with this decision because my equity on several other apartment and commercial buildings is working extremely hard and yielding nice results/cash flow. That’s the key to growing a real estate portfolio, create equity and make your equity/your cash, work hard for you (go read The Richest Man in Babylon if this concept is lost on you).
How equity doesn’t do much for you (using myself as an example).
In the case of my first house, even after giving myself credit for principal pay down I’m barely making 1.00% on my equity. That’s not 1.00% on how much money I put down when I originally bought the home, it’s my imputed equity in the house today (i.e., what it’s currently worth less what I owe). In my opinion this is the ONLY way to look at a rental property cash flow. In this post I’ll show you why.
“But I’m going to cash in big when the market rises,” and other excuses.
Maybe your property is in a hot up & coming neighborhood and you want to ride the wave a little higher before selling. Or maybe it’s unique or has some amazing features. Or maybe, like me, you have an emotional connection and you just can’t let go. That’s fine, if you don’t need the equity to work harder for you. But understand, you’re leaving substantial cash flow on the table.
How single family valuation makes equity investing a poor use of your money.
In tight real estate markets, like Southern California today, single family homes and condos typically don’t trade (sell), and typically aren’t valued, based on the cash flow they would generate as a rental property.
Rather, they typically sell at a price based on where the most recent comparable(s) traded, the income someone makes that would live there and the corresponding mortgage payment someone can afford. In other words, what is someone willing to pay to live there. You’re buying into a life/lifestyle, not a cash flowing investment. Which means that homes trade at a higher price than they should if they’re to be used as typical cash-flow investment properties.
Don’t believe me? Lets break it all down together.
Go to padmapper.com (excellent resource by the way), and search for a 3 bedroom 2 bath home, in a neighborhood like Normal Heights.[1] At the moment, I’m looking at a very nice detached home in great condition renting for $2,600/month + utilities.
In that neighborhood a comparable home would cost around $650,000 to buy. If you bought the home and put down 25% (or $162,500), that’s $162,500 in equity minus closing costs. But you’ll have closing costs on an apartment building purchase as well, so let’s call that a wash.
Say you get an interest-only loan at 4.25%, and receive $2,600/month in rent. You’re now up a whopping $170/month assuming as a landlord, you’re ONLY paying for taxes, insurance and the mortgage. That’s a 1.25% absolute best case scenario return IF you have no vacancy, no property management expense, no repair and maintenance bills, no landscaping expense, no nothing.
With a 30-year amortizing payment, you’re negative $500/month in actual cash flow. Yes, you’re paying down a little principal each month, but that’s not a very compelling argument is it?
It’s not looking great and we haven’t looked at all of your expenses yet.
But wait, there’s more! When figuring rental income on a home you really should take an expense figure for repairs of at least another $50-$100/month. Even if you don’t spend $50-$100 every month, you’ll likely spend several hundred every year, or $1,000 – $2,000 every few years. There are also management fees to consider, typically much higher for homes vs apartments, maybe 8-10% vs 5-7%. And you’ll need to calculate vacancy, typically 5% of income, just to be safe in today’s market.
With those realistic ownership expenses for a rental home, assuming the tenant pays for landscaping and utilities on top of their $2,600/month rent, you’re now losing over $200/month. Yeah, way less than awesome.
“But what if I find a really great deal?” you ask.
Fine, let’s say you get an amazing home for $550,000 instead (15% less than what the home is probably worth), and you find a tenant who would pay $2,700/month, you’re still only making about 1.5% on your equity (down payment) after realistic operating expenses.
Now lets compare the home purchase to an apartment building purchase.
Making the same calculations on apartment buildings in that same area, you’ll likely make at least triple the 1.5% in my example above, or 4.5%+.[2] Initially you may need to add some additional equity for rehab and downtime (vacancy), but the apartment investment will likely dwarf the returns from cash flow on a single family home.
Exceptions? Or, not so much?
A friend has some homes he rents out to college students and his return on equity (cash on cash return) is much higher.
Yes, but so are his repair and maintenance bills, turnover, rent collection headaches, management fees, etc. Student housing, vacation rentals, etc. can sometimes feel more like an operating business and less like a property rental business. Hey, there’s always a trade off.
An existing rental home you’ve had for years with a low property tax bill.
You’re also worried that if you sold that home to buy an apartment building there would be transaction costs/commissions/etc. that would reduce the cash (equity) you’d have to buy apartments with. Oh and, the tenant you have now has been there forever and pays on time every month.
Good points, so go ahead and run the numbers. Calculate the annual cash flow from your current rental home[3] and divide by the cash you’d have left if you sold the home (i.e., your imputed equity today). My guess, that figure is between 1-3% and you’re not accounting for the time (however rare or frequent) you deal with management yourself. On your rental home you may manage it yourself and say it’s very easy and always 100% occupied, so you don’t take the 8-10% property management fee. Fine, but I’m guessing your rent is below market and that return on imputed equity (cash on cash return) figure is still in the 1-3% range.
But won’t my home always go up in value in the long run?
Maybe, but no promises. And even if you could say that was true, wouldn’t apartments also go up in value? There’s definitely a correlation with real estate values in general. This is an entirely separate topic but think about it for a few minutes. As long as you don’t sell the home and sit on your cash, as long as you put it to work again back IN real estate in that same market, if your home would have increased in value in the years to come, your apartment building would likely do the same.
If I need to sell because I need the cash or have another attractive investment opportunity, it’s easy and fast to sell a home versus an apartment building.
Are you sure about that? If the market is hot for homes and the average time on market is say 15-30 days, that’s still WAY less than the national average. So an apartment building, if priced correctly, should sell as fast as a home. Also, the logic with apartments and apartment values is typically based on cash flow. So, if you offer apartments for sale at a price that yields an attractive cash on cash return and an attractive cap rate[4] the apartments should sell fast as well.
On a home I can get a 30-year fixed loan, versus apartments, which typically only offer fixed rates up to 10 years.
I understand that concern, and for the conservative long-term approach to debt, it sure is nice to know your interest rate is fixed for 30 years. While several apartment loans are available with 30 year terms as well, they’re sometimes only fixed for the first 5-10 years. So really think about the likelihood that you’ll actually keep the property or mortgage for a full 30 years, instead of selling or refinancing earlier. And if you’re one of those people, then you need to weigh the additional cash flow and refinance/future interest rate risk of apartments against a 1-3% return…
First time apartment buyer? Usually not a problem.
There are property management companies and lenders who will work with you depending on your credit and overall financial picture. Intimidated by the process of buying or the idea of owning a larger building as opposed to a home? Don’t be – every commercial property owner started somewhere. This is where you start.
[1] East of the 805, West of the 15, in San Diego, CA
[2] What you make a year NET of ALL actual expenses
[3] Income less vacancy and expenses = net operating income. NOI divided by purchase price = cap rate. Cap rate = your cash on cash return if you paid all cash for the building. NOI less mortgage payments = net cash flow. NCF divided by your down payment = cash on cash return.
[4] Nice to know since it’s a way to compare apples to apples, since cap rates are independent of how the loan impacts the economics of a building.
