This article was posted on Monday, Jul 01, 2013

Every once in a while it’s appropriate to devote a column to young people trying to get started.  An adult grandchild reading this might be willing to engage in a conversation that needs to be started.

This article will hypothesize a 17 year investment horizon because most young people have trouble visualizing a future longer than they’ve been alive. Seventeen years is workable: “Back then I was 6 and Daddy would drag me fishing and I had to sit quietly because he said I’d “scare the fish”. I hated that!” Most young adults can relate to 17 years but not 30.

So I got this email, which I’ll paraphrase, “I can’t invest now. I don’t have enough money. Prices are too high. I’ll just wait. [email protected]” .

Well, Samantha, I can’t comment on your objections. You probably haven’t enough money; most people don’t, and that’s a problem. You’ve got to find – or grow – the money somewhere.

When you get a little money you might be able to buy a single family residence or even a two unit property via a FHA loan. For example, at the time this is written you can buy a home, if you’re going to live in it, with as little as a couple of percent down. There will be other costs besides the down payment, but often the seller can be negotiated into paying many of them. Sometimes this requires adjusting the purchase price. You can also buy a three to four unit property (again, owner occupied) for just a little larger (percentage) down payment. If right now you can’t swing the down payment for a FHA loan, well, that’s what they make second jobs for. And just for the record, the maximum FHA loan for a fourplex in most places is currently $800,000.

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Although there are still affordable locations, overall apartment prices are about as high as I remember. We’ve been through the weak market of 2007 – 2009 and there’s no further softening on the immediate horizon. In many ways that’s very encouraging. Would you prefer to invest in something that’s going down? Rising prices are a good thing: they indicate that if you invest and you don’t make too many stupid mistakes, you can have a promising future.

Speaking of the future, your decision, “I’ll just wait”, does not guarantee that things will be better for you in the years to come. You’ll be making more money, but your expenses will be greater and property will cost more. Waiting only guarantees that you’ll wind up considerably poorer than you otherwise could be because there will be less time for your investments to compound.

Accepting all the obvious caveats (including but not limited to, meteor strikes, hyperinflation, nuked by North Korea, and mega-depression), let’s look at what could be one of your alternative futures. The choices you make today determine the future you earn.

  • Working assumption: You’ve been a weekend barista for a couple of years and you’ve managed to save the minimal down payment for an owner-occupied FHA financed fourplex. The purchase price was $800,000.

As you know, there are four financial advantages to income property:

  1. Appreciation. We expect the value of your building to increase at least as much as inflation.
  2. Equity Build-up.  Each loan payment you make pays down a little of your loan. If you financed the building over, say, 30 years at the end of that time the loan will be paid off. Letting your tenants pay off your loan is known as “equity build-up”.
  3. Depreciation.  There are tax advantages to owning income property.
  4. Cash Flow.  You pay the expenses and the mortgage from the rents collected.  What’s left over is the “cash flow”. Go shopping.

There’s a reason those four advantages were listed in the order they were. It’s because we’re only going to discuss the first two, appreciation and equity build-up. We shall absolutely ignore the tax advantages, which are beyond the scope of this article. And we’re going to pass over cash flow, even as we work very hard to increase it every year. In any event, whatever cash flow we get we expect to spend (see “d”: Go shopping) so it won’t contribute towards long term wealth.

To go forward, we have to agree on the working assumptions. Just to be conservative, could we stipulate that the building will appreciate exactly equal to inflation? Inflation in the United States has run an average of 4.23% annually since 1971, so we’ll use that number.

Conventional apartment financing (not entry level 1 – 4 unit FHA loans, but five units and above) doesn’t have the low down payment advantages of FHA mortgages; they have come to require about one-third (+/-) down. A $1 down payment will turn into $3 of equity when the loan is paid off in 30 years, which means we’ll have an average annual equity build-up of 3.73%.  Note: 3.73% times 30 years does not equal 100% because the fixed equity build-up number is taken on an ever- declining base. Just to be cautious, we’ll use 3.73% as the average equity build-up figure even if an FHA loan, due to its smaller down payment, would reasonably generate a higher equity build-up percentage.

Although inflation and equity build-up total 7.96% annually (4.23% inflation plus 3.73% equity build-up), it’s often better to not just lump them together and call it a day. The reason is that EBU is taken on a declining number and inflation is off an ever-rising number. We would be a little more accurate if we worked numbers separately before summing them.

We’re going to do most of our math through the Rule of 72 (a magic number). If we divide that number by the interest rate, we’ll get the number of years it’ll take to double our money.

  • Example: How many years will it take to double our money using the historical inflation rate only? 72 divided by 4.23% equals 17 (rounded) years to double. 

Caution! From this point on we’ll be doing a thought experiment and we’re going to be ball parking numbers. We’ll round figures (up or down) to make the arithmetic easy enough to do in our heads. The purpose of what follows is to propose a format for an investment plan and a possible direction of gain. You are free to ignore everything that follows (naturally, except my phone number when you need a loan), plug in your own numbers if you wish, or even change the format to something else entirely.

Ok, Samantha, let’s say you buy a cute little fourplex for $800,000 with FHA financing then you go back to sleep, waking up seventeen years later to find you still owe $492,000 on the original mortgage.

What’s your equity in these four units, 17 years in the future? Well, we’ve used the Rule of 72 to forecast that the units would double. They would be worth $1,600,000. Subtract the $492,000 owed and your equity is $1,108,000. You have turned $40,000 into $1,100,000 (rounded) in 17 years: a yield of 21.53% annually.
If you’d not borrowed to finance your purchase you could have bought only a $40,000 property and your  “forced savings” would have been the 4.23% from inflation (again, on a $40,000 base). After 17 years your property would be worth $81,000. As a new investor, Samantha, reflect on that for a moment. Proper use of Other People’s Money is a major key to success in apartments.

Remember, this was not active management: you’ve been asleep the last 17 years! On a conceptual level, some folks might think this pretty much establishes the lower limit of investment growth.

Samantha, let’s drill down and see where this fourplex investment might take you at various intervals along the way.

EOY 1:  Beginning of Year 1) Purchase that fourplex we talked about earlier for $800,000 through the FHA low-down-payment-for-owner-occupants loan program.

EOY 6:  (End of Year 6) At 4.73% annual appreciation the building will be worth about $1,000,000 in 6 years. Your tenants would have paid the loan down to $700,000 (rounded), so you won’t be able to pull money out at the end of the first six year period, Your equity will have only grown enough to barely qualify for a conventional 30% down refinance loan. (Explanation: Value EOY 6 equals $1,000,000. If the bank requires 30% equity the new loan will be $700,000. That will just pay off the existing FHA loan. Everything has worked as expected (the building has gone up with inflation and the tenants have paid down the FHA loan, but that just brings you to the point where you can be emancipated from government financing if you wish.

EOY 12: Another six years passes and you’ve had the original building for a total of 12 years. The building’s value is $1,300,000. The purchase loan has been paid down to almost $600,000. You’ve turned $40,000 into $700,000 ($1,300,000 minus $600,000) in 12 years: you’ve made 26.94% per year on your down payment (not including tax advantages or cash flows).

EOY 17: Property value: original building $1,600,000. Loan balance: $492,000. Equity: $1,100,000. Annualized yield: 21.53%.

Let’s stop here for a moment and reflect. These initial 17 years are going to pass regardless of what the young investor does. She could be frivolous with the extra money from her barista job and, 17 years later, find herself still competing for tips, but now against younger and prettier girls. Or she could follow this brief outline and in seventeen years have over $1 million equity in income property. At 8% average annual gain (inflation plus equity build-up) her forced savings come to $80,000 annually. What barista saves $80 grand a year? There is a huge difference in lifestyle, Samantha, between those who leave tips and those who wait for them. If you want to earn a place on that train – there are seats available – you have to start saving for the ticket now. You have to do it. Nobody buys a ticket for somebody else, but when you do manage to get on that train your life changes. Magic happens: King’s Cross Station, platform 9 ¾.

A fourplex isn’t the only possibility. There are other investment alternatives. You could have put the down payment ($40,000) in a good S & P 500 Index fund. Over the past 36 years a fund like that has appreciated about 9.2% a year (average), so over a random 17 years your $40,000 would have grown to $178,500.

Alternatively, you could have invested with Warren Buffett by buying stock in Berkshire Hathaway (BRK). That stock has increased 19.7% annually from 1965 through 2012. Using that growth figure, over an average 17 year time frame your $40,000 would have grown to $850,000.

What you did do, Samantha, was mix coffee drinks on weekends until you had the necessary down payment on a small rental building. Then you quit Starbucks. That fourplex was the only investment you made your entire life. Seventeen years along the equity you have in your building – already over $1,000,000 – is growing at $80,000 a year ($1,000,000 x 7.96%). Your investment is doing better than if you’d put the original $40,000 in to Berkshire Hathaway. Don’t tell Warren.

Caution! The key to high yields in investment real estate is high underlying financing. As the loan is paid down your yield reduces. Once the mortgage is paid off, your equity won’t continue to grow at 7.96% (combined) because there’s no more equity build-up . . .  until you refinance in which case it all starts over again). Your property will, however, probably keep appreciating at the rate of inflation (4.23%).

The reference to stocks can be used to guide the conversation in an important direction. Why would a person invest in real estate rather than stocks? It’s this:

  • Tipping Point:  There are very good investment advisors who will tell you what their mother’s told them, that you must put a little aside and invest regularly all your life. It seems that doesn’t have to be the case. If, through leverage (income property) or brilliance (Warren Buffett) you can generate sufficient yield there will come a time when it no longer makes any difference if you add new contributions. That is the inflection point where your money is working for you. That point can come sooner with real estate.  

If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].





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