Investments can do different things, but no individual investment can do conflicting things. That’s because some desiderata are mutually exclusive. For example, we can’t maximize portfolio growth unless we borrow money to do it. And we can’t maximize safety if the apartment building is mortgaged. In countries where mortgages are unknown, foreclosures are equally unknown.
Conflicting investment goals come from the effort to maximize. To maximize leverage is to borrow every possible dollar out of available equity, but that means there is less cash flow. To maximize cash flow is to be tempted to charge over-market rents (probably requiring the landlord to accept tenants other owners have rejected), but that means collection difficulties. These and other decisions determine the scope of financial benefits available to the landlord.
There are four sources of income to an apartment owner. These are appreciation, depreciation, equity build-up, and cash flow. An income property investment could, depending on the decisions made, check each of these boxes. Alternatively, an owner may elect to emphasize one benefit to the reduction or exclusion of another. That’s a wonderful thing about rental properties: each property has a buffet-like choice of benefits, and the owner can select a new plate of benefits with each purchase.
A matrix of the possible benefit buffet follows. This example has the four sources of income listed horizontally across the top and the investment’s desired characteristics listed vertically along one side.
|Appreciation||Cash Flow||Depreciation||Equity Build-up|
How this chart is filled in is dependent on where a person is in their investment career and what he wants his investments to do. Parents who are facing college expenses in three years need safe investments. If they lose principal there isn’t time for them to recover before Brittney’s tuition must be paid and her living expenses provided for. On the opposite end, a young person with thirty or forty years for his investments to compound is in a much different place. As the middle ground, a retired couple living off their rents, dividends and interest requires some growth (at least enough to track inflation) like the young investor, but with as much safe cash flow as reasonably attainable. The key here is to know what you want your investments to do for you, and then select from the buffet accordingly.
Let’s consider Harriet’s situation. She’s a middle-aged secretary for a parsimonious DUI attorney with a comb-over. She is single and lives within her limited means. Harriet’s only family is Caleb, her much younger half-brother from her father’s third wife, who just turned 21 and supports himself. She recently inherited (Thanks, Aunt Ida!) a run down but mortgage-free eight-unit apartment building and for the first time in her life she’s thinking that she won’t have to work until she’s dead . . . that she might actually be able to retire.
Harriet has given her windfall much thought and understands that in retirement she will need more income than the apartment building generates in its current condition. Thus, immediately quitting work is out of the question. Furthermore, at some future time she may become physically or mentally unable to continue managing the building, so she wants the option of cashing out and living off bond interest (which she hopes will be higher then) and stock dividends rather than apartment rents. Thus cash flow (to renovate the building and earn higher rents now and to support herself later) and appreciation (to eventually generate a livable income from non-realty sources) are important to her.
The first question Harriet considers is whether or not to mortgage the eight units. She inherited the building with no debt. If she borrowed the renovation costs she could have the building fixed up a lot faster and re-lease at higher rents. She’s still new to this field, but she thinks higher rents may make the building worth more to a buyer. That’s important because she doesn’t exactly know when she or her possible conservator might have to sell the building.
The other side of this is that she’ll have to evict the tenants before fixing up the building. Once that happens, the building will generate absolutely no income during the renovation period, but ownership costs will continue. Tax bills will come. The insurance agent will demand his check. If the gardener isn’t paid the weeds will grow and the flowers decline. The rubbish bill will probably increase because of the renovation detritus and all. And after all that she’ll be facing 30 years of loan payments.
Harriet is opposed to debt of any kind, and the thing that really sticks in her craw is that if she mortgages these eight units her total cost to amortize the loan will be roughly three times the original amount she borrows (monthly payments x 360 months minus original amount borrowed). She will, in a very real sense, be spending her future income today. Every time she thinks about that, thrifty Harriet gets a sour taste in the back of her throat. Parsimony is contagious.
Harriet expects her building to appreciate over time. It’s a matter of faith to her: as far as she knows it always has, so it always will. If she looked into it, she’d probably find that property is composed of (a) the land and (b) the improvements. Left alone, the improvements wear out at about the rate that construction and material costs go up, so that’s pretty much a wash. The root source of appreciation is really the land. The value of land tends to go up at the rate of inflation plus the rate of population growth within the land’s specific market area. But Harriet’s blind faith in appreciation comforts her, and she doesn’t need a calculator.
Harriet already lives within her modest salary. She even has some small savings, so she has no immediate need for additional income. Harriet elects to let the cash flow accumulate and expects to renovate the units during normal tenant turnover. It will take longer, but there is less overall risk. She has determined that, at this time, the most important things are maximum safety and appreciation sufficient to offset inflation. It’s a little safer not to have a mortgage, but there is a penalty. With no leverage, if her building appreciates 10% her equity will be increased 10%. If she had even a 50% loan on the property, a 10% appreciation factor would result her equity increasing 20%. But Harriet has nobody to provide for her so she sleeps better when she carries minimum risk. Having made that decision, she turns to her diversification buffet and looks for the benefits she wants. She ticks the boxes under Appreciation / Safety and Cash Flow / Liquidity.
Appreciation with safety comes when unleveraged property goes up in value. Harriet understands that if the property had a loan on it, especially an adjustable rate loan, and rates climb significantly things could go very wrong for her.
Cash flow with liquidity is associated with an unleveraged state. Harriet has no mortgage payments to make so her NOI becomes her cash flow and goes right to her savings account. During the financial troubles of 2000 and 2008 we saw how quickly property value can drop. When leveraged property drops beneath the level of its existing loan, liquidity is hampered. If that happened again and she had to sell she could lose everything.
Harriet has clearly biased this investment towards security. Given her situation, it is appropriate for her to do so. With no underlying loan, she has exchanged Equity Build-up / Leverage for maximized cash flow.
She ticked the Depreciation / Safety box almost as an afterthought because she has learned it is pretty much automatic – tax depreciation is independent of loans.
Coincidently, Aunt Ida bequeathed an identical building to Caleb. It was built by the same contractor at the same time, from the same plans, with equivalent materials, on a similar lot in the same neighborhood. At the time the transfer was made, Caleb’s property was in comparable condition to Harriet’s. Aunt Ida’s Will provided that Caleb and Harriet were treated equally, so what might happen next depends on their individual decisions.
Caleb’s situation, however, is materially different from his older sister’s. Caleb has forty or more years to go before reaching traditional retirement age. That gives him the option, if he wishes, to be more aggressive in his investment career. He simply has more time to recover from errors he might make.
He has absolutely no experience in running an apartment building, and, unlike Harriet has no desire to learn. He contracted with a professional off-site property manager on a trial basis. Even at first, Caleb was apprehensive about the arrangement. Frankly, it didn’t work out immediately and he changed management companies a couple of times in the first year or two. But he’s learned more about being a landlord now, and after six or seven months with the most recent manager he has reached his comfort level.
Caleb often admired how Aunt Ida lived off of her rents and that’s what he wanted to do, but not in the modest manner of Aunt Ida, who died with 16 units. Caleb wanted to die with hundreds of units.
Once he got the management situation squared away, Caleb started working his plan. He put as big a loan on the property as he could. The principal amount was limited by the net rental income and by Caleb’s global cash flow (see February, 2015) and in this case turned out to be about 60% of the building’s full market value. There was no underlying loan to pay off, so what he got was enough for a reasonable down payment and closing costs on a 12 unit building in the same area (with some money left over). Caleb had gone from nothing (“You want fries with that?”) to the owner of 20 units within three years. His diversification buffet looked like this:
|Appreciation||Cash Flow||Depreciation||Equity Build-up|
Notice that Harriet organized her affairs to maximize cash flow and security over equity build-up and leverage. Caleb, on the other hand, chose different items from his buffet. He arranged things to maximize portfolio growth. They both received (albeit in different degrees) appreciation, cash flow, and tax benefits. The difference between them is that Caleb uses leverage so he gets equity build-up, too.
In Harriet’s defense, there’s certainly nothing wrong with owning one or more apartment buildings free of loans, especially (as in her case) when approaching retirement. But this degree of security comes with a price. Under the restrictions Harriet has placed on herself, unless she can come up with a large sum of money from another source she’ll never be able to buy an additional building. She would have to save out of cash flow not just the down payment but the entire purchase price of her next acquisition. While she’s saving, the value of apartment buildings (if recent history is any guide) will continue to appreciate. It would be unusual if she could ever catch up.
Caleb, on the other hand, makes haste slowly. He didn’t borrow against his eight units until he had satisfactory management in place, then he borrowed carefully and bought wisely. Recall that he did not buy a property that required all his cash reserves. Caleb can be expected to continue buying in this way for the next several decades. Once he approaches retirement, it is reasonable for him to move towards paying off his apartment debt to maximize his cash flows and minimize his risk. We’ll discuss a way he might do that next month.
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]. 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 guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com