In a post awhile ago (2009?), I wrote about Dave's three steps to wealth creation. Step 2 was to review and categorize your transactions. Step 3 was to have a cost out meeting with yourself (and your spouse). Once you have been using Mint.com for a month or two, you should sit down in front of your computer and go through in detail every transaction. If you don't know what it is, ask your spouse. If you still don't know what it is, you should leave it in uncategorized. You should keep working on your uncategorized category until it is less than 5% of your total spending. The uncategorized bucket is not your friend! One way of making sure that you know every expense is to check for new expenses every night. Then you will not have forgotten what it was before you categorize it. It may be seen as some as a bit obsessive, but obsession is not always a bad thing. especially if the thing you're obsessing about is important.
Note: Using your debit card for everything will help you keep track of all of your expenses, while using cash will not allow you to see the vendor for each transaction. There are benefits to using cash, but I lean towards the debit piece.
So, now you have your expenses categorized. Sit down and determine if there is anything you don't need. When our son was born in '04, we had three cars -- two were paid for (a 99 camry and a 98 ford ranger) and I was leasing a Saab for around $330/month. We got rid of the Saab. It was like giving myself a $4000 raise (after taxes), so really more like a $6000 raise.
I looked at our Comcast bill last month. I was paying $184 for Internet, Cable TV and Home Phone. We never use our home phone, and lots of telemarketers call it. And I realized that for Cable TV, I only watched about 6 shows each week, and I could either get them free on Netflix (well, included in the $7.99/month fee) or buy them per episode on Amazon Video on Demand (for my Tivo), or iTunes for my iPad. I added up the total if I bought 22 episodes/year for $2 each, for 6 shows. It came in under $300. So I cut off my Cable and Phone, and reduced my $184 to $39.99 for Internet. Even if you add in the $300, my savings this year will be ($184-$40)x12-$300= $1428. If you made that into before tax money, it's like giving yourself a $2000 raise.
Now you might not have as obviously wasteful things like these that you can eliminate from your budget, but there may be other things. Do you drive to work? I pay $80 for parking, plus another $30-40 in gas per month. That's over a thousand dollars a year in savings. How often do you eat out, how much do you spend there. Mint should be able to tell you that. If you use your debit card at Starbucks, you should be able to see how much you spend at Starbucks. Some people spend $5/day, for 250 work days/year, so $1250, or just over $100/month. Do you eat out for lunch at work? Do you pay $1.50-$2 every day for a coke with your lunch? Water is better for you and cheaper. Coffee is free at work, and even better, you could give up coffee and sleep better at night.
Ok, identify three areas where you can remove cost (take cost out) of your monthly budget.
Next post -- reducing credit card debt! I will try to get to this later today.
Sunday, January 23, 2011
Thursday, December 16, 2010
The Ups and Downs of being a Landlord
So, things have gone well this year. I refinanced a couple places, my adjustable rate mortgages have adjusted down, I am actually cash flow positive on some of the houses, I am paying down about $3k/month in debt. I'm about to close on 8 more units in Buffalo. Overall, it has been a good year.
(that's the ups). Now for the downs. I got a call from the property manager last night (while I'm in London for business) that the rain in Seattle flooded the basement of one of the houses. She said that we'll have to replace the carpet, and even some of the drywall. The tenant, who has been in the house for over 3 years, moved out and isn't coming back. This will be an expensive week.
The good news is that they have paid for december, so we have two weeks to get the house in shape before the new year. We are also going to try to raise the rent 10%, since we have not changed it for the last three years, and the market seems to be picking up a bit. That would be +$1800 cash flow for the year (although that will all probably be spent on replacing carpet and drywall, and the remortgage fee.
Oh well. We will continue to plug along and roll with the punches.
For more suggestions, stories and strategies for real estate investing, take a look at this book at Amazon:
(that's the ups). Now for the downs. I got a call from the property manager last night (while I'm in London for business) that the rain in Seattle flooded the basement of one of the houses. She said that we'll have to replace the carpet, and even some of the drywall. The tenant, who has been in the house for over 3 years, moved out and isn't coming back. This will be an expensive week.
The good news is that they have paid for december, so we have two weeks to get the house in shape before the new year. We are also going to try to raise the rent 10%, since we have not changed it for the last three years, and the market seems to be picking up a bit. That would be +$1800 cash flow for the year (although that will all probably be spent on replacing carpet and drywall, and the remortgage fee.
Oh well. We will continue to plug along and roll with the punches.
For more suggestions, stories and strategies for real estate investing, take a look at this book at Amazon:
Tuesday, December 14, 2010
Increasing Net Operating Income
I've talked a bunch about buying property in previous posts...the logistics of financing, the cap rates on some of my properties, finding properties in different markets. Once you've bought the property, what do you do then? Since commercial properties are valued based on the Net Operating Income (NOI), one of the best ways to increase value is to increase NOI. There are multiple ways to this, and you should do all of them.
The most obvious is to raise the rent! Keeping operating expenses equal, if you raise the rent, you will raise NOI - which affects both cash flow in the short term and property value/sales price in the long term, as property value is a multiple of the NOI. Some of the things you can do which may allow you to raise the rent:
Rehab the inside of the property. You have to do some of this when a tenant moves out anyway -- clean or replace carpets, paint the interior. Other things which I did were to install bathroom fans in all of my units. When I toured the apartment before buying, I could see and smell the moisture in the units. By installing bathroom fans, it significantly dried out the places and improved the smell. One hint if you do this: wire the fan into the light switch so it comes on any time the tenant turns the light on. This will help keep moisture down.
Install nice countertops. Ideally one could install corian, but that could be expensive. You can get nice (or at least nicer) formica countertops. These make a difference and will help you land better tenants, which in turn reduces wear and tear and tenant turnover, again increasing NOI.
Clean up the exterior. I try to stop by my apartment building at least once a month and the first thing that strikes me is how the place looks. The last time I went by, I saw some of the shrubs were overgrown, the leaves from the local tree were piling up around the place, and the stairs up to two of the apartments were very dirty, despite the painting they got this summer. I asked the property manager to have these things cleaned up. Hopefully, if we treat the property well, the tenants will too.
In addition to raising rents, the other way to increase NOI is to reduce expenses. There are several expenses that you can reduce, some of which are easier than others.
Interest expense
Principal
Taxes
Utilities
Maintenance
The first two, principal and interest, are not always in your control. Although with this economy and interest rates low, it is worthwhile to investigate whether a refinance pays for itself. I recently refinanced from 5.375% 30 year fixed to a 3.875% 5 year arm. This reduced my payment by about two hundred dollars/month and turned that property from negative to positive cash flow. The interest savings pays for the closing costs in about two years. After that, the interest savings is incremental $ in my pocket.
Reducing your principal expense can be done by moving to an interest-only loan, although these are much harder to get then they were a few years ago, especially for investment properties.
You should keep an eye on your property tax assessments and bills. Most counties have a process for appealing the valuation if you feel that the property has been assessed unfairly. I haven't been successful getting my taxes reduced, but some people make a business out of helping people appeal to the county.
Utilities is an expense you should be pretty aggressive about. Ideally, you want tenants to pay all of the utilities. That way it doesn't cost you anything if they take a long shower or leave the lights on, or the door open. In my building, the tenants pay electricity and there is no gas. Unfortunately, the water/sewer/garbage is billed as a package by the city, rather than individual units. I charge the tenants a "utility fee" of $35 per person on top of their base rent, to cover w/s/g. this comes to about $350/month total. Recently I looked at my w/s/g bill and found that it was $500/month. I sent the property manager to investigate, and she found that one of the bathtubs had a leaky faucet. We replaced that and also installed low flow showerheads and aerators on all of the taps (The city provided these for free, and would've given us free toilets too if ours were older). I am considering "submetering" each apartment for water, which would allow us to bill each tenant separately for this, and align their incentives with mine -- ie keeping water usage low. Studies have shown that submetering can reduce water usage costs by 35% because the tenants are responsible for their own usage. I investigated with one company, and they estimate submetering my seven unit building would cost about $5k including installation. I haven't decided if it's worth it yet. If I could save $50/month, the ROI would be about 4 years to earn back my money, which seems like a long time. But I also have to consider how much value this would add to the sales price. $50x12 = $600. With a cap rate of 5%, which is not unreasonable in Seattle, the $600 saved per year would turn into $600/.05=$12,000 in additional property value. With 6% cap rate, it would be about $10k. This makes it look like a good investment -- if I can really save the $50 or more.
The garbage bill is another frustration point. I pay $215/month for a 1.5 cubic yard dumpster with once a week pickup. I pay $0/month for the same size dumpster for recycling. My tenants fill up the garbage dumpster, but I only saw about four pieces of cardboard in the recycling 75dumpsters. One of my goals for 2011 is to reduce the garbage produced by half, and move that to recycling, and thus reduce my cost for garbage pickup. If you want more suggestions on how to reduce your garbage bill, I found a company called Waste Auditing Consultants. Their business model is to help companies reduce their garbage bill, and then they split the savings with the owner. The owner is a guy named Trip Topken, and they work with folks with garbage bills from $400/month to $375,000. Trip gave me some other tips on using a compacting dumpster, talking with the city about alternative carriers and reducing my expense through negotiating my rate with the city.
If anyone else has suggestions, please feel free to post a comment in response to this post!
The most obvious is to raise the rent! Keeping operating expenses equal, if you raise the rent, you will raise NOI - which affects both cash flow in the short term and property value/sales price in the long term, as property value is a multiple of the NOI. Some of the things you can do which may allow you to raise the rent:
Rehab the inside of the property. You have to do some of this when a tenant moves out anyway -- clean or replace carpets, paint the interior. Other things which I did were to install bathroom fans in all of my units. When I toured the apartment before buying, I could see and smell the moisture in the units. By installing bathroom fans, it significantly dried out the places and improved the smell. One hint if you do this: wire the fan into the light switch so it comes on any time the tenant turns the light on. This will help keep moisture down.
Install nice countertops. Ideally one could install corian, but that could be expensive. You can get nice (or at least nicer) formica countertops. These make a difference and will help you land better tenants, which in turn reduces wear and tear and tenant turnover, again increasing NOI.
Clean up the exterior. I try to stop by my apartment building at least once a month and the first thing that strikes me is how the place looks. The last time I went by, I saw some of the shrubs were overgrown, the leaves from the local tree were piling up around the place, and the stairs up to two of the apartments were very dirty, despite the painting they got this summer. I asked the property manager to have these things cleaned up. Hopefully, if we treat the property well, the tenants will too.
In addition to raising rents, the other way to increase NOI is to reduce expenses. There are several expenses that you can reduce, some of which are easier than others.
Interest expense
Principal
Taxes
Utilities
Maintenance
The first two, principal and interest, are not always in your control. Although with this economy and interest rates low, it is worthwhile to investigate whether a refinance pays for itself. I recently refinanced from 5.375% 30 year fixed to a 3.875% 5 year arm. This reduced my payment by about two hundred dollars/month and turned that property from negative to positive cash flow. The interest savings pays for the closing costs in about two years. After that, the interest savings is incremental $ in my pocket.
Reducing your principal expense can be done by moving to an interest-only loan, although these are much harder to get then they were a few years ago, especially for investment properties.
You should keep an eye on your property tax assessments and bills. Most counties have a process for appealing the valuation if you feel that the property has been assessed unfairly. I haven't been successful getting my taxes reduced, but some people make a business out of helping people appeal to the county.
Utilities is an expense you should be pretty aggressive about. Ideally, you want tenants to pay all of the utilities. That way it doesn't cost you anything if they take a long shower or leave the lights on, or the door open. In my building, the tenants pay electricity and there is no gas. Unfortunately, the water/sewer/garbage is billed as a package by the city, rather than individual units. I charge the tenants a "utility fee" of $35 per person on top of their base rent, to cover w/s/g. this comes to about $350/month total. Recently I looked at my w/s/g bill and found that it was $500/month. I sent the property manager to investigate, and she found that one of the bathtubs had a leaky faucet. We replaced that and also installed low flow showerheads and aerators on all of the taps (The city provided these for free, and would've given us free toilets too if ours were older). I am considering "submetering" each apartment for water, which would allow us to bill each tenant separately for this, and align their incentives with mine -- ie keeping water usage low. Studies have shown that submetering can reduce water usage costs by 35% because the tenants are responsible for their own usage. I investigated with one company, and they estimate submetering my seven unit building would cost about $5k including installation. I haven't decided if it's worth it yet. If I could save $50/month, the ROI would be about 4 years to earn back my money, which seems like a long time. But I also have to consider how much value this would add to the sales price. $50x12 = $600. With a cap rate of 5%, which is not unreasonable in Seattle, the $600 saved per year would turn into $600/.05=$12,000 in additional property value. With 6% cap rate, it would be about $10k. This makes it look like a good investment -- if I can really save the $50 or more.
The garbage bill is another frustration point. I pay $215/month for a 1.5 cubic yard dumpster with once a week pickup. I pay $0/month for the same size dumpster for recycling. My tenants fill up the garbage dumpster, but I only saw about four pieces of cardboard in the recycling 75dumpsters. One of my goals for 2011 is to reduce the garbage produced by half, and move that to recycling, and thus reduce my cost for garbage pickup. If you want more suggestions on how to reduce your garbage bill, I found a company called Waste Auditing Consultants. Their business model is to help companies reduce their garbage bill, and then they split the savings with the owner. The owner is a guy named Trip Topken, and they work with folks with garbage bills from $400/month to $375,000. Trip gave me some other tips on using a compacting dumpster, talking with the city about alternative carriers and reducing my expense through negotiating my rate with the city.
If anyone else has suggestions, please feel free to post a comment in response to this post!
Tuesday, November 23, 2010
How did I ever choose Buffalo/Western NY as a place to invest?
After my last post, I had a comment from a realtor in Buffalo who wanted more details on how I decided that Buffalo is a good place to buy property. So here's the (perhaps convoluted) logic that brought me to Buffalo.
I have purchased several properties in Seattle over the last six years (4 single family residences, and most recently a 7-unit apartment, all within a few miles of my house. (98117 zip code if people are interested in seeing the area.) I also have a day job which funds these acquisitions, so I need to keep my time investment per property at a minimum. The problem with Seattle is that the cap rate is very low. For Single Family/duplexes, it's around 4%. For the apartment, I got what I think is a great deal at around 8%, although I had to put about $40k into it once I had purchased it. So including that, the cap rate is about 7-7.5%. The <4 unit properties are cash flow negative to start and for the foreseeable future with 30-35% down payment.
So one night I couldn't sleep, so I did a search for "turnkey investment property" in Google. One of the results that came up was http://www.cashflowwithequity.com/. This is a firm which buys properties in Buffalo, rehabs it, puts a Section 8 renter into the property and sells it to you. When you do the calculation, these end up being about $200/month cash flow positive on a purchase price of $60k or so. This is much better than -$400/month on an investment of $350k in Seattle. I was wary of finding a company like this on the internet and investing sight-unseen. So I did a search for Commercial Real Estate in Google, and found http://www.loopnet.com. I did a search for multifamily properties in Buffalo and Rochester and found many properties for similar prices (a duplex for $60k or less, with cap rates of 10-12%). I then decided that maybe this is real, and property really is cheaper outside Seattle!
I discussed with my realtor in Seattle, David Sligar, who has worked with me to purchase the 11 units in Seattle. I asked him to join me for a trip out to Western NY for a few days to look at properties. He couldn't make it, but did find me realtors in Buffalo and Rochester, through a nationwide referral service. He interviewed the guys and set up first conversations with them. He will get a referral fee on any properties I buy through them.
Next, serendipity intervened. I knew I wouldn't buy any properties remotely without at least getting to know the cities and the people I would be working with. So I had been thinking about taking a trip to Western NY. It turned out that in September, my company was sponsoring a recruiting trip for our team to Toronto. I volunteered and the company covered the expense of getting me to Toronto. After our recruiting was done, I rented a car and drove down to Buffalo and Rochester. I met with the agents there, Mark Hiscock in Rochester and Corey Rossi in Buffalo. They each had found 4-5 properties for me to walk through, and we also drove by some of the properties that I had found on Loopnet. The Loopnet properties were in somewhat dicey neighborhoods, and Mark and Corey warned me away from these. I also met with the guys from "cashflowwithequity.com" and they showed me around their duplexes for sale. Corey warned me away from them with a set of reports from ripoffreports.com, where people had complained about shoddy work from these guys.
Anyway, we didn't find anything on that trip that resonated with me. Corey and Mark both set up automated searches for me which sent me properties which fit my parameters. Corey also followed up a few weeks later, pointing out a set of four duplexes next to each other which were for sale. Assuming we close, the potential cap rate is 10-12% and the cash-on-cash return in the first year will be 16-18%. Not too bad...And as an added bonus, they're on a commercial lot so I will have the option to build something else in the future if the opportunity presents itself.
Corey also introduced me to a Property Management company, Superior Management Services, in the Buffalo area. They walked through the properties with him, and gave me suggestions for areas for improvement (although they're in pretty good shape now). I am headed out there in December to do my own walk through before we close.
If you're interested in investing in multifamily real estate, I recommend Investing in Apartment Buildings: Create a Reliable Stream of Income and Build Long-Term Wealth
, available on Amazon in paperback or Investing in Real Estate which you can get on your Kindle Wireless Reading Device, Wi-Fi, 6" Display - with New E Ink (Pearl) Technology
or in paperback.
.
I have purchased several properties in Seattle over the last six years (4 single family residences, and most recently a 7-unit apartment, all within a few miles of my house. (98117 zip code if people are interested in seeing the area.) I also have a day job which funds these acquisitions, so I need to keep my time investment per property at a minimum. The problem with Seattle is that the cap rate is very low. For Single Family/duplexes, it's around 4%. For the apartment, I got what I think is a great deal at around 8%, although I had to put about $40k into it once I had purchased it. So including that, the cap rate is about 7-7.5%. The <4 unit properties are cash flow negative to start and for the foreseeable future with 30-35% down payment.
So one night I couldn't sleep, so I did a search for "turnkey investment property" in Google. One of the results that came up was http://www.cashflowwithequity.com/. This is a firm which buys properties in Buffalo, rehabs it, puts a Section 8 renter into the property and sells it to you. When you do the calculation, these end up being about $200/month cash flow positive on a purchase price of $60k or so. This is much better than -$400/month on an investment of $350k in Seattle. I was wary of finding a company like this on the internet and investing sight-unseen. So I did a search for Commercial Real Estate in Google, and found http://www.loopnet.com. I did a search for multifamily properties in Buffalo and Rochester and found many properties for similar prices (a duplex for $60k or less, with cap rates of 10-12%). I then decided that maybe this is real, and property really is cheaper outside Seattle!
I discussed with my realtor in Seattle, David Sligar, who has worked with me to purchase the 11 units in Seattle. I asked him to join me for a trip out to Western NY for a few days to look at properties. He couldn't make it, but did find me realtors in Buffalo and Rochester, through a nationwide referral service. He interviewed the guys and set up first conversations with them. He will get a referral fee on any properties I buy through them.
Next, serendipity intervened. I knew I wouldn't buy any properties remotely without at least getting to know the cities and the people I would be working with. So I had been thinking about taking a trip to Western NY. It turned out that in September, my company was sponsoring a recruiting trip for our team to Toronto. I volunteered and the company covered the expense of getting me to Toronto. After our recruiting was done, I rented a car and drove down to Buffalo and Rochester. I met with the agents there, Mark Hiscock in Rochester and Corey Rossi in Buffalo. They each had found 4-5 properties for me to walk through, and we also drove by some of the properties that I had found on Loopnet. The Loopnet properties were in somewhat dicey neighborhoods, and Mark and Corey warned me away from these. I also met with the guys from "cashflowwithequity.com" and they showed me around their duplexes for sale. Corey warned me away from them with a set of reports from ripoffreports.com, where people had complained about shoddy work from these guys.
Anyway, we didn't find anything on that trip that resonated with me. Corey and Mark both set up automated searches for me which sent me properties which fit my parameters. Corey also followed up a few weeks later, pointing out a set of four duplexes next to each other which were for sale. Assuming we close, the potential cap rate is 10-12% and the cash-on-cash return in the first year will be 16-18%. Not too bad...And as an added bonus, they're on a commercial lot so I will have the option to build something else in the future if the opportunity presents itself.
Corey also introduced me to a Property Management company, Superior Management Services, in the Buffalo area. They walked through the properties with him, and gave me suggestions for areas for improvement (although they're in pretty good shape now). I am headed out there in December to do my own walk through before we close.
If you're interested in investing in multifamily real estate, I recommend Investing in Apartment Buildings: Create a Reliable Stream of Income and Build Long-Term Wealth
, available on Amazon in paperback or Investing in Real Estate which you can get on your Kindle Wireless Reading Device, Wi-Fi, 6" Display - with New E Ink (Pearl) Technology or in paperback..
Wednesday, October 27, 2010
Property in Buffalo!
Hi all, it's been a long time since I posted on the blog. I'm a Seattle native and have been buying properties in Seattle for the past few years. The one house I wrote about earlier, along with three other single family homes. Earlier this summer I bought a seven unit apartment down the street from me, and this actually is cash flow positive in months where there are no discretionary expenses (above taxes, utilities, insurance and property management). The single family houses are starting to break even after several years of losing money.
So, I started looking at other areas of the country for places which are "cheaper." How is "cheaper" defined? One measure of cheaper is the Cap Rate, short for Capitalization Rate. The capitalization rate is the Net Operating Income (NOI) divided by the purchase price. In Seattle, the apartment I bought was a bargain at 8% (I bought it for $612.5k and the NOI was around $49k. After I put about 40-50k into the place to upgrade electrical, pour a new sidewalk, rehab four units, put in new awnings, the cap rate including that expense was closer to 7%.
In buffalo, I am finding properties with 10-12% cap rates. I just bought four duplexes (8 units) for $334k (roughly half what I paid for the seven units in Seattle) with about the same NOI. Well, I haven't closed yet but I'm under contract. My realtor in Seattle found me a realtor in Buffalo, my realtor in Buffalo found me a property management company, so I don't have to fly out there so often. Looking forward to clearing $1500-2k/month on an initial investment of around $100k. We'll see if it pans out I guess!
So, I started looking at other areas of the country for places which are "cheaper." How is "cheaper" defined? One measure of cheaper is the Cap Rate, short for Capitalization Rate. The capitalization rate is the Net Operating Income (NOI) divided by the purchase price. In Seattle, the apartment I bought was a bargain at 8% (I bought it for $612.5k and the NOI was around $49k. After I put about 40-50k into the place to upgrade electrical, pour a new sidewalk, rehab four units, put in new awnings, the cap rate including that expense was closer to 7%.
In buffalo, I am finding properties with 10-12% cap rates. I just bought four duplexes (8 units) for $334k (roughly half what I paid for the seven units in Seattle) with about the same NOI. Well, I haven't closed yet but I'm under contract. My realtor in Seattle found me a realtor in Buffalo, my realtor in Buffalo found me a property management company, so I don't have to fly out there so often. Looking forward to clearing $1500-2k/month on an initial investment of around $100k. We'll see if it pans out I guess!
Monday, December 28, 2009
Wealth Creation, part 2: Real Estate as a meaningful component of your portfolio
Why is it good to have Real Estate as a part of your portfolio?
There are several reasons, but the main differentiator between real estate and other investments is Leverage. What is leverage? It's also called Other People's Money (OPM) and probably other things. Leverage is buying an asset by putting a small (or large) fraction of the money down yourself, and borrowing the rest. This means that not only is your money working for you but other people's money is working for you too.
When you invest in the stock market, your money is working for you, and you'll see increases of 8, 10, maybe even 12% per year on your initial investment. In real estate, you put a down payment (the standard is 20%, but I've bought houses before with as little as 3% down (although this is harder today than it used to be).
Let me give you an example:
I have $10,000 to invest. I can do one of two things with it.
1) I buy a Dow Jones Industrial index fund with my $10,000. The stock market has an exceptionally good year and increases 15%, and I end up next December with $11,500. My return on investment is $1,500/$10k = 15%.
2) I use my $10,000 as a down payment on a $50,000 house. I borrow the other $40,000 from the bank (OPM). In the next year, the house appreciates 5% (a realistic appreciation historically) and the house is worth $52,500. I still owe $40k (well, probably more like $39,500 because I've paid down a little bit of principal). So my equity (defined as the value of the house minus the mortgage) is $52.5k - $39.5k = $13k. So my Return on Investment is $3k/$10k = 30%, twice the return of the optimistic stock in the example above.
One could get even more aggressive, and take the $10k and split it and buy 2 houses, with $5k (10%) down each. If each of the houses increased by 5% to $52, 500, the total would be $105k. So your return on investment would be $5k/$10k = 50%! The more leveraged you are, the better the return.
To be completely transparent, leverage can work against you too (as it did with many people in the last year of economic downturn) if the value of the house went down 10% from $50k to $45k in example 2, you would have lost half of your down payment, and you would be down from $10k equity to $5k, or a 50% (unrealized) loss. So what do you do if this happens? Nothing! Real Estate has gone up over any 5 year period over the last 100 years. So you should just keep collecting rent, keep making your mortgage payments and wait it out.
Next post: What is cash flow?
There are several reasons, but the main differentiator between real estate and other investments is Leverage. What is leverage? It's also called Other People's Money (OPM) and probably other things. Leverage is buying an asset by putting a small (or large) fraction of the money down yourself, and borrowing the rest. This means that not only is your money working for you but other people's money is working for you too.
When you invest in the stock market, your money is working for you, and you'll see increases of 8, 10, maybe even 12% per year on your initial investment. In real estate, you put a down payment (the standard is 20%, but I've bought houses before with as little as 3% down (although this is harder today than it used to be).
Let me give you an example:
I have $10,000 to invest. I can do one of two things with it.
1) I buy a Dow Jones Industrial index fund with my $10,000. The stock market has an exceptionally good year and increases 15%, and I end up next December with $11,500. My return on investment is $1,500/$10k = 15%.
2) I use my $10,000 as a down payment on a $50,000 house. I borrow the other $40,000 from the bank (OPM). In the next year, the house appreciates 5% (a realistic appreciation historically) and the house is worth $52,500. I still owe $40k (well, probably more like $39,500 because I've paid down a little bit of principal). So my equity (defined as the value of the house minus the mortgage) is $52.5k - $39.5k = $13k. So my Return on Investment is $3k/$10k = 30%, twice the return of the optimistic stock in the example above.
One could get even more aggressive, and take the $10k and split it and buy 2 houses, with $5k (10%) down each. If each of the houses increased by 5% to $52, 500, the total would be $105k. So your return on investment would be $5k/$10k = 50%! The more leveraged you are, the better the return.
To be completely transparent, leverage can work against you too (as it did with many people in the last year of economic downturn) if the value of the house went down 10% from $50k to $45k in example 2, you would have lost half of your down payment, and you would be down from $10k equity to $5k, or a 50% (unrealized) loss. So what do you do if this happens? Nothing! Real Estate has gone up over any 5 year period over the last 100 years. So you should just keep collecting rent, keep making your mortgage payments and wait it out.
Next post: What is cash flow?
Saturday, December 26, 2009
The Rule of 72 and Intention-Manifestation
I'm going to talk about one widely accepted mathematical truism and one crazy non-fact-based idea in this post.
First, the Rule of 72. Once you have started to track your net worth, you need to figure out how fast it's growing and whether that's fast enough. One way to understand the speed at which it is growing is to use the Rule of 72. It says that if you start with 72 and divide it by the annual growth rate (in percent) that you're growing, this will tell you how long it will take (in years) to double your net worth. So for example, if your net worth is growing at 6%/year, it will take 12 years to double your net worth. At 10%/year, it will take just over 7 years. And so on. This is an approximation that works at low fractions, so as you get to bigger growth rates it is less accurate. So if you want to double your net worth in 3 years, you will have to grow at 26% (rather than the expected 24%). And this compounds...so that if you are growing at 12%, it will take 6 years to double, and another 6 years to double again. So in 12 years, you will have quadrupled your net worth.
Exercise: Get out your calculator or excel spreadsheet and figure out how fast are you growing and how long it will be til you can retire. There are other variables to take into account to determine retirement age, but you can take a swag at it using a 4-5% fixed income rate of return once you retire. So if you have a net worth of $1M, you would be able to earn $40-50k/year from that.
The second exercise I think is a little nutso, but it doesn't cost much. Many, many books on wealth creation and other things say that the first thing that you should do is write down your goals. This will help you achieve them (This is called the intention-manifestation model, but I'm not going to dive too deep into that here). Choose how much you want to grow the net worth in the next year, three years and five years. Even starting with one year is a good place to start. I decided that my goal is to double my net worth every 3 years. I have a little post it note widget in the corner of my screen which says Grow Net Worth by 26% in 2010, from xx to yy. I then calculated whether this was realistic. I used a simple rate of 7% appreciation in the Seattle real estate market and a 10% appreciation in the stock market (these are not super-ambitious numbers, but not super-conservative either). So I ended up with four areas of net worth growth.
Real estate appreciation
Stock/mutual fund appreciation
Loan pay down
Surplus added to my investments
Real Estate Appreciation
: The important thing to remember about this number is you take the appreciation based on the total asset, NOT based on the equity in the house. So let's say I have a house worth $500k and a mortgage of $400k. My equity (which is added into my net worth) is $100k. But when I calculate my 7% increase in the value of my house, it's 7% of $500k = $35k. So while the property only gained 7%, the net worth increase of the real estate part of my portfolio is 35%. This is what "leverage" is all about. The more leveraged you are (leverage = property value/equity), the more an increase will effect your net worth. I should also note that the same is true for a decrease. The more leverage you are, the more trouble you could get into if the property value decreases (which we saw in 2008-2009). 80% Loan to Value = 5x leverage. 90% LtV = 10x leverage. One of the challenging things about this is that as your property value increases, your LtV decreases and your leverage decreases. So you need to monitor this value over time. I should talk about that separately.
Stock/mutual fund appreciation: This is not leveraged, so just take your total amount invested in the market, and multiply it by 10% (historic appreciation of the dow over 10 year time period) to calculate the increase. You could make a more sophisticated formula, but it's probably worthwhile to keep it simple.
Loan pay down: Look at your last mortgage statement and see how much principal you paid last month. Multiply that by 12 and it will tell you roughly how much principal you will pay down this year. In general this is << the change you'll see due to Real Estate Appreciation, at least for the first fifteen years or so of the loan. Each year it gets a little bigger though.
Surplus added: This is the money you are left with after all the bills are paid each month that you can invest for the long term. You can increase this by doing a "cost out" exercise (see previous post) or by investing your bonus or other non-periodic income such as stock options which vest quarterly, and living on your monthly income. The cost out exercise is what's sometimes known as "the latte factor
" or by other names.
If you add these four things up and find you're light to your goal, you should try to figure out what you can do to increase one or the other. Can you take some cost out of your everyday life and add that to your surplus? Do you need to add some higher-growing real estate to your portfolio? Can you pay a little extra down on your mortgage or credit card bills?
That reminds me. When I said Loan pay down, I should have included other debt besides mortgage -- credit card debt (that's the worst), auto debt, etc etc. Credit card companies are and credit card debt is evil. Before doing any of this other stuff, make sure and pay down your credit card debt! This deserves a whole separate post.
First, the Rule of 72. Once you have started to track your net worth, you need to figure out how fast it's growing and whether that's fast enough. One way to understand the speed at which it is growing is to use the Rule of 72. It says that if you start with 72 and divide it by the annual growth rate (in percent) that you're growing, this will tell you how long it will take (in years) to double your net worth. So for example, if your net worth is growing at 6%/year, it will take 12 years to double your net worth. At 10%/year, it will take just over 7 years. And so on. This is an approximation that works at low fractions, so as you get to bigger growth rates it is less accurate. So if you want to double your net worth in 3 years, you will have to grow at 26% (rather than the expected 24%). And this compounds...so that if you are growing at 12%, it will take 6 years to double, and another 6 years to double again. So in 12 years, you will have quadrupled your net worth.
Exercise: Get out your calculator or excel spreadsheet and figure out how fast are you growing and how long it will be til you can retire. There are other variables to take into account to determine retirement age, but you can take a swag at it using a 4-5% fixed income rate of return once you retire. So if you have a net worth of $1M, you would be able to earn $40-50k/year from that.
The second exercise I think is a little nutso, but it doesn't cost much. Many, many books on wealth creation and other things say that the first thing that you should do is write down your goals. This will help you achieve them (This is called the intention-manifestation model, but I'm not going to dive too deep into that here). Choose how much you want to grow the net worth in the next year, three years and five years. Even starting with one year is a good place to start. I decided that my goal is to double my net worth every 3 years. I have a little post it note widget in the corner of my screen which says Grow Net Worth by 26% in 2010, from xx to yy. I then calculated whether this was realistic. I used a simple rate of 7% appreciation in the Seattle real estate market and a 10% appreciation in the stock market (these are not super-ambitious numbers, but not super-conservative either). So I ended up with four areas of net worth growth.
Real estate appreciation
Stock/mutual fund appreciation
Loan pay down
Surplus added to my investments
Real Estate Appreciation
: The important thing to remember about this number is you take the appreciation based on the total asset, NOT based on the equity in the house. So let's say I have a house worth $500k and a mortgage of $400k. My equity (which is added into my net worth) is $100k. But when I calculate my 7% increase in the value of my house, it's 7% of $500k = $35k. So while the property only gained 7%, the net worth increase of the real estate part of my portfolio is 35%. This is what "leverage" is all about. The more leveraged you are (leverage = property value/equity), the more an increase will effect your net worth. I should also note that the same is true for a decrease. The more leverage you are, the more trouble you could get into if the property value decreases (which we saw in 2008-2009). 80% Loan to Value = 5x leverage. 90% LtV = 10x leverage. One of the challenging things about this is that as your property value increases, your LtV decreases and your leverage decreases. So you need to monitor this value over time. I should talk about that separately.Stock/mutual fund appreciation: This is not leveraged, so just take your total amount invested in the market, and multiply it by 10% (historic appreciation of the dow over 10 year time period) to calculate the increase. You could make a more sophisticated formula, but it's probably worthwhile to keep it simple.
Loan pay down: Look at your last mortgage statement and see how much principal you paid last month. Multiply that by 12 and it will tell you roughly how much principal you will pay down this year. In general this is << the change you'll see due to Real Estate Appreciation, at least for the first fifteen years or so of the loan. Each year it gets a little bigger though.
Surplus added: This is the money you are left with after all the bills are paid each month that you can invest for the long term. You can increase this by doing a "cost out" exercise (see previous post) or by investing your bonus or other non-periodic income such as stock options which vest quarterly, and living on your monthly income. The cost out exercise is what's sometimes known as "the latte factor
" or by other names.If you add these four things up and find you're light to your goal, you should try to figure out what you can do to increase one or the other. Can you take some cost out of your everyday life and add that to your surplus? Do you need to add some higher-growing real estate to your portfolio? Can you pay a little extra down on your mortgage or credit card bills?
That reminds me. When I said Loan pay down, I should have included other debt besides mortgage -- credit card debt (that's the worst), auto debt, etc etc. Credit card companies are and credit card debt is evil. Before doing any of this other stuff, make sure and pay down your credit card debt! This deserves a whole separate post.
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