Everybody wants something but it doesn’t always happen, and that was how I spent the last two years of high school. I wanted to go to Europe with my (chaperoned) youth group the summer before my senior year. I baby-sat and tutored and saved every dime I could, but my trip to Europe never happened. The money just wasn’t there. That was the second important lesson of my life: day labor doesn’t pay for European vacations. Sigh.
The first lesson, learned prior to kindergarten, was that if you throw a tantrum and your mother doesn’t let you go to the party you’ll never get any ice cream.
While it’s true that we don’t always get everything we want (the high school lesson), we’ll get nothing if we don’t show up (the kindergarten lesson). It seems to be a universal law, because it works with almost everything I can think of. It sure works with investments.
Obviously, showing up is vital to a young investor-in-training. If she doesn’t start, she’ll never get any ice cream. But it’s also important to a seasoned investor. Buying another property — showing up – again and again and again, is how several of my long-term clients have turned, over time, a small apartment building into portfolios that dominate their respective neighborhoods. Showing up is not something we do once and never again. It’s a life-style.
Here’s how important it is. We’ll use the Rule of 72, where you divide the yield (in decimals) into 72 and the result will be the approximate number of years required for your money to double. If you’re aspirational, you can use the number 115 and get the years to triple. If you’re almost clinically hopeful and thought you could spend two weeks inEurope, use 144 and you’ll find the years for your money to quadruple.
Say you’re 37 years old and have $500,000 in various assets (home equity, stock portfolio, life insurance, etc). You think you could probably put the money to work elsewhere and get a (hypothetical) 10% total return. What could your assets grow to by the time you’re 65?
Step 1: Divide 72 by 10(%) and you’ll find it will take (about) 7 years for your assets to double.
Step 2: 65 minus 37 means your money will be compounding for 28 years, or four 7-year (doubling) periods.
Step 3: After one doubling, the $500,000 would turn into $1 million. The second doubling brings the $1 million to $2,000,000. At the third doubling your investments go to $4,000,000. The fourth doubling raises it to $8 million.
Had you not managed your assets to grow at 10% annually, do you really think you’d retire with eight million dollars? Not sure? Ask your wife.
While nothing is guaranteed, this is where the hypothetical 10% might come from. You know, because we’ve talked about it, that there are four sources of income from investment real estate. They are not equal and they happen at different times during the holding cycle. The four are appreciation, depreciation, equity build-up and cash flow.
In no particular order, let’s try to get an idea what these four items might total. We’re going to stipulate that the purchase involves a $1,000,000 property bought at a 6% cap rate with 30% down and a 15 year fixed rate mortgage at 5%.
When next you talk with your accountant, ask her if the following is materially correct – depreciation allowances permit the owner to legally presume that a certain portion of the improvement value wears out every year. That amount can be “depreciated” from the building’s cash flow each year, year after year, until it’s all gone. Income taxes are not immediately due on the amount depreciated: taxes are deferred until the property is sold. At time of sale, if the property sells for more than its then-depreciated (book) value, the accumulated depreciation becomes taxable. The investment benefit is that income from earlier years that would have been taxed at ordinary income rates is now moved to long term capital gain rates, which is usually less than ordinary tax rates.
Example: That $1,000,000 property consists of $600,000 land value and $400,000 improvement value. The owner keeps the property long enough to fully depreciate it, thus not paying ordinary income taxes (assume 30%) on $400,000. The owner would have postponed paying $120,000 of ordinary income taxes. Assume a 30 year hold.
Eventually, she sells the property for many times what she bought it for three decades earlier. Since the higher sale demonstrated that the improvements did not in fact wear out, postponed taxes on the depreciated amount are now due. The investment benefit is that the amount deferred has become classified as long term capital gains because the property was held more than one year. Long term capital gains are normally taxed much less than ordinary income. As a hypothetical example, instead of paying 30% taxes on $400,000 ($120,000 due) the seller will owe 20% taxes ($80,000 due). Depreciation allowed the property owner a $40,000 benefit over 30 years or about $111 a month. That’s less than a good babysitter earns.
We’re not going to count $111 a month towards our $8,000,000 goal. For our purposes, this article zeros out depreciation benefits. They exist, as we’ve shown, but your accountant may agree that they are not without claw-back.
If the building value stays the same the $300,000 down payment will turn into $1,000,000 equity when the tenants pay off the loan in 15 years. That’s contractual. To do this the average annual Equity Build-up figures to be 8.3%.
1: Determine the NOI: $1,000,000 times .06 means the Net Operating Income (what’s left over after paying all of the building’s fixed and variable expenses except the mortgage payment) is $60,000.
2: Determine the maximum loan payment the bank will allow on that specific NOI: $60,000 NOI divided by 1.20 debt coverage ratio (DCR) means there will be $50,000 available for annual debt service, or about $4,200 a month. Initial cash flow forecasts at $10,000 a year – (NOI minus debt service), or about 3.30% of the down payment. To put this into perspective, on the day this is written 10 year Treasury bonds yield 2.93%. The dividend yield for the S&P 500 is 1.90%.
Income properties appreciate in two ways: inflation and cap rate changes. Inflation increases the value of existing income properties because a cheaper (inflated) dollar means it will take more dollars to build a competing product. Even the land value will be affected by a cheaper dollar. This sort of appreciation doesn’t mean you’re wealthier: you can still buy only the same number of bananas. It does, however, move you into a higher tax bracket, which the government seems to like a lot. Example: You buy a building for $1,000,000 and years later sell it for $3,000,000, which happens to be exactly equivalent to the inflation-adjusted $1,000,000 you paid. Even though your profit is due exclusively to the government’s currency machinations, you’ll still be taxed on $2,000,000 of phantom “gain”.
Since inflation does not fundamentally benefit your wealth – no increase in bananas – we’ll not be counting it towards our 10%.
Cap rates fluctuate with the interest rate cycle, and changes in capitalization rates affect the value of existing streams of income in very meaningful ways (see below). The best investments are purchased at a high cap and sold at a low cap. The formula for capitalization is Net Operating Income divided by Cap Rate equals Value.
- Example 1: $60,000 divided by 0.12 (12%) equals $500,000.
- Example 2: $60,000 divided by 0.06 (6%) equals $1,000,000
The difficulty we’re facing is that there’s just no way to be sure what cap rates will be when we sell. If they’re lower than when we bought, we’ll have a gain; if they’re higher, we might (depending on what’s happened to our NOI) be facing a loss. We just don’t know for sure.
So let’s suppose that cap rates when we sell are exactly the same as when we bought, but that Net Operating Income (NOI) increased at 3% annually. We bought at a $60,000 NOI, kept it (example) ten years and sold at an $80,000 NOI. Capitalized at our original 6%, the value of that property is $1,333,000. We’ve turned an original investment of $300,000 into $633,000 (includes getting our original $300,000 back) in ten years: that’s a 7.7% annual appreciation (compounded).
Experienced apartment operators will notice that this example excluded some sources of income and minimized others. On the other hand, it doesn’t include the buyer’s costs when purchasing the property, or the owner’s costs when selling. We’re just going to stipulate that these are rough offsets and that the example figures are approximations.
Are We There, Yet?
- Depreciation Token
- Equity Build-up 8% average
- Cash flow 3% initially
- Appreciation 7% forecast
That’s a total of 18%, so it looks like a splendid retirement may be possible . . . if you show up.
Disclaimer: This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.
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].