So, I was going over my personal financial statements today. I make it a habit to do this at the beginning of every month, and being that it is the beginning of the year, I also like to spend some time looking at how we did over the past year with our finances. I really had a good laugh when I took a look at how my 401k performed this past year (although I should be crying).
At first glance, I thought I had done pretty good because my account balance is actually up from where it stood at the beginning of the year. However, after looking a little closer, the reason my balance is up is because of the loan payments (I quit contributing 3 years ago) I made to the account. If you take out my loan payments, I had a net loss of $429.53 for the year. Really, a loss?!?!?
So I decided to look into things a little further. With my 401k I’ve taken a simplistic approach and I simply invest in the S&P500 because most funds don’t beat the S&P on a yearly basis and it really simplifies everything. So, if you look at the S&P 500, we started the year at 1271.89 and it closed the year at 1257.60 for a loss of 1.1%. So, it makes sense that I lost money.
But I didn’t stop there…I decided to look at my 5 year performance. To my dismay the loss has been even bigger over the last 5 years – the S&P500 is down 11.3% since January 2007.
Okay, so I haven’t made any money over the past 5 years, so I decided to go all the way back to when I first opened my 401k. I’ve been at my job since January of 2000, and I opened my 401k in April of 2000. To my dismay, the S&P500 is down over 16% since April of 2000. This represents an annual loss of approximately 1.3% every single year I’ve been investing in the S&P 500. At this rate I’m doomed to be greeting shoppers at Wal-Mart.
Honestly, this simple exercise of looking over my 401k performance over the last year has confirmed to me why Kelly and I have quit investing in the stock market and we’re putting all of our money into real estate.
Now, let’s compare this putrid performance in the stock market with just one of our property investments – 630 Lydia in Pontiac, MI.
We purchased this property in August of 2010 for $17,500 (yes that figure is right). When we purchased, we took out a loan of $12,000 on the property, so our actual investment in the property was $5500. So let’s take a look at how we did with this property – here are the actual numbers from this past year:
Rental Income – $11,815.92
Property Expenses – $6,890.68
Mortgage – $1,320.00
Cash Flow $3,605.24
So we made $3,605.24 on this one property last year making a 65% return on our $5,500 investment – a tad better than what I got out of my 401k. Perhaps I might be able to skip the Wal-Mart gig after all.
Honestly, I’ve been thinking about cashing in my 401k for a while now and putting the funds into real estate. Even with the penalties and taxes I would have to pay to cash it in, I’m confident I will be much farther ahead buying a few more rental properties. After looking at the performance over the past year, I’ve decided it’s time. The 401k is going to get cashed in and we’re going to be purchasing some more property.
Well today is day 45 in our drive for $60,000 in 60 days, and we had a little bit of an interesting situation that came up on one of the properties we’re selling. We received the title search back from the title company and the following line item appeared on the title report”
Payment Agreement and Lien in favor of Charter Township of Waterford dated May 1, 1975 and recorded June 12, 1975…
My first reaction was…what the heck is this! We had purchased the property in March of 2009, and this never came up on the title report back then, so I immediately responded to the title company asking what this was.
They did in fact send me a recorded document showing that in 1975 the township of Waterford levied a special assessment against the property for the installation of sewers. The total assessment was $1,840, and furthermore it specified that an interest rate of 6.5% would be levied on the lien. So being an engineer with a great story problem in front of me, I quickly calculated what the total amount due would be if this lien had in fact gone unpaid all of these years. It turns out the balance would be well over $17,000!!!
I began to smile…yes, I began to smile, because I knew that we were protected from this sort of thing because we had in fact purchased title insurance when we bought the property back in 2009.
As it turns out, Kelly took a trip down to the Waterford Township offices, and as expected the title company had missed the recorded document discharging the lien against the property. The assessment was actually paid off in 1975, so there was no issue. However, had there been an issue, our title insurance would have saved us the $17,000.
The moral of the story here is never buy a property without title insurance!
As we discussed earlier this month a couple vacancies in our properties really killed our cashflow. We were still cash flow positive, but our net was much lower than it could have been if we had tenants in all of our properties. Well, we’re happy to announce that we’ve filled both of our vacancies with very good tenants, and we’ll be showing a much better number this month.
For the first property, we were able to obtain a rent rate about $50 higher than we anticipated, so this was very good news. This is a credit to our property manager who had 10 showings setup on the same date literally a few days after we purchased the property. We’ve completed the rehab on the property just in time, and the tenant has moved in as of last Friday.
For the other property, the rent rate wasn’t quite as good. We accepted a rate about $35 per month lower than anticipated, but our decision was based on the financials. We could have held out for another tenant, but the property has been on the market for about 45 days at this price. We’ve already had 2 weeks of vacancy, so the prospect of longer vacancy would continue to eat at the profits from this rental. So, looking at the numbers we think this was the correct decision. Over the next year, we’re going to collect $35 less than anticipated on this property which totals $420 for the year. This equates to little more than 1/2 of a month of rent. Since the prospects were not good that we would have the vacancy filled in the next 2 weeks, we accepted the tenant at the lower rate accepting the loss but avoiding additional losses.
This past Saturday we attended a great real estate networking event put on by Mark and Nora Ijlal in Southfield. This event included 3 speakers lots of networking a great spread of food for lunch, and the best part was that the proceeds for the event were all donated to charity. I have to say that Mark and Nora are true professionals at what they do, and it was clear by the full crowd that participated in the event. This was probably the best event we have attended this year.
Whenever Kelly and I attend one of these events we come home fully energized to keep moving forward to build our real estate investing business. Networking events are fantastic for a number of reasons:
The People – Of course the whole reason to attend a networking event is to meet people with similar interests to yours.
The Stories – Without a doubt, you’re going to have some excellent conversations with a number of people and in the process you’re going to hear some great stories.
The Conversation – The expectation at these events is that you get together with other folks and you can talk about your business.
The Perspective – As you build your business, you may have questions, and talking with people can provide a different perspective on a problem you are facing.
The Referrals – Talking with other real estate investors is a great way to get referrals for people to use in your business.
The Information – Events like this normally have great speakers (this one had 3!) and they normally provide numerous great tips for investing in real estate.
The Ideas – Without a doubt you always leave these events with at least one idea that can improve your business…most times you leave with several.
The Food – This is probably the most important part because as some of you may know, I like to eat. These events are almost always accompanied by food which is just fine with me!
All-in-all it is very easy to be excited coming home from these events, and the difficult part is usually figuring out what you’re going to do first. We have a long list of stuff from Saturday to implement…
3 bed / 1 bath Brick Ranch with Basement & 2-Car Garage
As we talked about earlier in the week, we spent the good part of this past Saturday putting together the numbers on a rehab in Waterford, Michigan, and the numbers looked good. The property shown in the picture above is a great little 3 bed / 1 bath brick ranch with a full basement and 2-car garage that really just needs some updating. The house is solid from top to bottom with no structural issues and the roof is great. Everything is telling us this is a great little property, and so we submitted the offer on Saturday night.
Since then we’ve been back and forth with the seller, and right now we’re at a bit of a stalemate. Originally we had planned to put the property under contract with a financing contingency because we were planning to fund the deal through a hard money lender. With the analysis we have put together I am confident that we could obtain the funding, but I cannot be 100% certain, so we need the financing contingency. This is a major issue for the seller, and they are requesting a $5000 deposit with no contingencies on the offer. In addition to this, they are asking that we close in 14 days.
Unfortunately, we’re not in a position to put the property under contract right now, but if we are able to locate private funding, we could easily snatch this deal up and be off and running with the rehab.
Right now we’ve completed a full analysis of the property and we’re reviewing this analysis with a few private lenders. We don’t have the funding lined up just yet, so if you are interested in partnering with us on this deal, we would be happy to discuss the full details with you as well. For now, here is a summary of the numbers:
For those that don’t know, we’re right in the middle of purchasing a property in West Bloomfield that we are planning to rehab. We have the property under contract, and we are currently within our inspection period that is written into the contract. Over the weekend we had bids come back from two of our contractors, and the news is not good. Originally we estimated about $25,000 in repairs to the property, but the bids coming back are closer to $40,000.
Unfortunately, this overrun in the repair estimates is not something we can absorb into our numbers. So, we spoke with the seller yesterday to present the bad news and requested we be released from the deal. We have protected ourselves with our 21 day inspection clause, so we’re not at risk to lose our earnest money deposit, but this is obviously not how we wanted this deal to turn out. At this point the only way we see this deal moving forward is if the seller can come down on their purchase price. We have requested a $15,000 reduction in purchase price, but we’re not real confident this is going to happen.
Today is Day 51 in our drive for $60,000 in 60 days through real estate investing. Over the last couple days we have come across three new deals, and we are working through our analysis of these properties.
West Bloomfield Ranch
We have submitted an informal offer through email on this property, but it seems to be much lower than what the seller is looking for. We are discussing our selection of comparables with the seller and they have brought up some good points about our comp selection, so we are going to look at this a little more closely and see if it makes sense to come up on our offer price. This is strictly a numbers game, and if the numbers don’t make sense, we won’t be coming up on our offer price…we will see…
Sylvan Lake Ranch
We have done the analysis on this property, and there really just isn’t enough equity in the property to be able to wholesale it, so we are going to offer the potential to lease option the property. With this, we can offer a full price offer to the seller, but we will lease the property from them for the first 3-5 years. That way they will be getting a monthly cashflow from the property, and we will be building up credits towards the down payment on the property. In 3-5 years, we will execute the final sale. This is beneficial for the seller because they will get cashflow, and they will receive their full asking price. It is beneficial for us because we will find a tenant for the property that will pay a little bit more in rent each month than what the seller is charging us, and we will give them an option price just a little bit higher than what the seller is charging us. Therefore, we too will make cashflow during the 3-5 years, and we will make a profit on the back-end. We will see how this goes, it is really up to the seller as to whether they want to get into this kind of arrangement or not.
Highland Duplex
We have completed our analysis on this property, and we will be submitting a verbal offer to them today. Our offer will be low because we plan to try to wholesale the property, so we will see what they say. The property does need quite a bit of work, but it would make a great rental property if it were fixed up. We will see how this one goes.
Pontiac Property
We are working with our hard money lender to finalize the closing date on this property. Right now we are trying to get it setup for August 24th.
Highland Property
We have another showing tonight with a buyer that has given us a verbal cash offer on the property. Of course we have two land contract offers on the table right now, but we are leaning towards the cash offer even though it is lower to avoid the risks involved with the land contract. We will see how this goes tonight.
Today is Day 22 in our drive to freedom. We have two properties under contract that we are actively marketing, and we are getting calls each day on both. Hopefully it’s just a matter of time before they are sold.
Now, today we are going to dive back into our series on the Anatomy of A Deal. In Part 1 we talked about how to find properties and qualify sellers. So now that you have found a property and you have qualified the seller, it is time to run the numbers to see if it truly is a good deal.
When looking at any investment, you should always ask yourself WHAT IS MY RETURN ON INVESTMENT? Your return on investment (ROI) can be described by a simple formula:
ROI = R / I
Where R = Gross Return, I = Amount Invested
ROI is always calculated on an annual basis, so if your numbers are not based on 1 year, you will need to adjust them so they are based on 1 year.
Now, there are several ways to make money on each property and you can break them into the following categories:
Cashflow
Appreciation
Depreciation (Tax Benefit)
Interest Deduction (Tax Benefit)
Principal Loan Reduction
We will talk about each of these briefly.
Cashflow
Cashflow is the income that is produced by a property after all expenses including debt service are paid. When calculating cashflow, many make the big mistake of just subtracting their mortgage payment, taxes & insurance (PITI) from the rent and call that cashflow. However, as an investor you need to be aware that there are many more expenses involved with the operation of a rental unit. The following expenses should also be included when calculating cashflow:
Vacancy
Property Management
Pest Control
Maintenance
Legal Fees
Office Supplies
Association Fees
Utilities
Landscaping
Advertising
You can see this is a significant list, and in many cases the tenant may pay for some of the expenses (like utilities), but you should at least consider each of them. So, to calculate the cashflow, simply take the rent and subtract all of your expenses, mortgage payment, taxes and insurance.
Appreciation
Appreciation is simply the amount of money made on a property that is bought and sold.
Now, appreciation can be natural or forced. Natural appreciation is just the gradual increase or decrease in a property’s value due to market conditions. (Note, appreciation can be negative.) Forced appreciation, is where you are forcing the property to appreciate. An example of this is when you rehab a property. You buy it in a distressed state, and when you fix it up, you force the property to appreciate.
Now, with any exit strategy that involves selling the home (i.e. not renting) then you need to determine how much you are going to be able to sell the home for. If you are rehabbing, this is referred to as the after repair value (ARV). If you are wholesaling, you need to understand what kind of discount your end buyers are expecting to purchase for. If you are doing a lease option, you need to understand what the market appreciation is to determine what the option price should be at the end of the lease.
Now, I will make a few comments on After Repair Value (ARV) which is the value you will want to establish if you are rehabbing or wholesaling a property. To determine ARV, you need to look at what homes in the area have sold for that are similar in age, size and construction. Normally we like to have at least 3 comparable homes that we can calculate an average price per square foot. We then apply this price per square foot to the home we are looking at to arrive at the value. Normally, we also like to go and look at the comparable homes to get first hand knowledge of them to determine if the number we are calculating is a good number. If we seen things that make the comparable homes better or worse, we may adjust our number from their.
I will also mention that you should not forget about other costs that may be involved with the deal. For example closing costs, holding costs and repairs should all be figured into your calculation on appreciation.
So, to calculate appreciation, take what you expect to sell the propety for and subtract what you have put into the property including purchased price, repairs, holding costs, and closing costs.
Depreciation
You’re probably thinking that depreciation doesn’t sound like a good thing…and how the heck am I going to make money from it? Well as it turns out, depreciation is a very good thing. In fact, for many sophisticated investors it is their favorite form of income from an investment property because it can literally turn the return from red to black.
So what is it? Well, in an effort to encourage investment in real estate, the Federal Government has setup a tax deduction where you can deduct the depreciation of an investment property. In actuality, the property may be increasing, but it does not matter. This is referred to as a paper loss, because you didn’t actually lose the money, but the government is allowing you to take the deduction.
Now, there are rules on how the deduction is calculated and how much you can deduct, and I encourage you to consult with your tax accountant on this. For practical purposes however, I will give you some rules of thumb.
For residential property, you can depreciate the property over 27.5 years.
For commercial property, you can depreciate the property over 39 years.
Generally depreciation is limited based upon your income and/or your profession. Speak with a tax accountant about this. (One hint: Ask how to be classified as a real estate professional because if you can, there are virtually no limits on the depreciation deduction you can take)
Only the improvements to the land are deductible. The land is not. A good rule of thumb is about 75% of what you paid for the property and improvements is deductible. Again speak with a tax accountant on this.
You must have income to deduct the depreciation against, in other words, if you have no income, you cannot take the deduction.
Now, to calculate the depreciation on a property you can use the following formula
Depreciation = 75% x B x T
B = Basis (amount you purchased the property plus any improvements made)
T = Federal tax bracket you are in
Again I will mention that this calculation is a rule of thumb and you will need to speak with your tax accountant to get the absolute amount you can deduct. This calculation will get you pretty close though.
Interest Deduction
Many are aware of the interest deduction that is taken against their personal homes, and it works pretty much the same way with investment property. The interest paid on debt service used to purchase the real estate is generally deductible. To calculate this you can use the following formula:
Interest Deduction = I x T
I = Interest paid
T = Tax
Principal Reduction
Principal reduction is just simply the amount your loan is reduced over a 1 year period. You can calculate this using an amortization table of your loan by looking at what the principal loan balance after 1 year compared to the original loan balance.
Putting it All Together
I understand that this is a lot of information to put together. I would recommend you put together an Excel spreadsheet to make these calculations to avoid mistakes.
In the Parts 3-5 of this series we will go through example calculations on how we analyze specific types of deals – wholesales, rehabs, & rentals. Stay tuned…
Okay, it’s day 6 and our efforts are starting to pay off a little bit. We’re in contact with 3 sellers right now, and we’re going to go out to take a look at a property in Highland Township today. The property is a 2 bed, 1 bath 1050 sqft single family home that is currently gutted. According to the seller there are about $25,000 in repairs but when finished it will be valued at $80,000. This might be our first deal!!!We have a meeting with the seller tomorrow, so we’ll keep you posted…
For the rest of the day we’re heading over to my mom’s and then we’re going to check out the fireworks in Lake Orion. Hope everyone has a safe and happy 4th of July…
So, I was going over my personal financial statements today. I make it a habit to do this at the beginning of every month, and being that it is the beginning of the year, I also like to spend some time looking at how we did over the past year with our finances. I really had a good laugh when I took a look at how my 401k performed this past year (although I should be crying). 
3 bed / 1 bath Brick Ranch with Basement & 2-Car Garage
