Rewind the clock a couple years back in time and you’d find that my perception of investing in real estate has changed dramatically. Prior to educating myself and running calculations I was opposed to the idea of this. My previous bias against real estate was formulated from my observations of real estate investors in my community. They all seemed stretched thin for time and overwhelmed. They were stressed, and any interaction with them was brief and frantic – the opposite of the lifestyle I want.
My previous bias strongly conflicted with the biases my wife’s family held. They claimed to have made their money in real estate – in fact my wife’s uncle was a major developer of lakefront property. He unfortunately died before I could meet him and pick his brain on the topic. I’m sure he’d have become somewhat of a mentor if he was still alive, and he may have been able to sway me earlier.
About a year before writing this, I joined a local real estate investor meetup. The founding member of this meetup group recommended I look into Bigger Pockets. At the time of his recommendation I was in the process of remodeling my basement and I discovered their podcasts, which was fortunate timing. I run a very full schedule and their podcast made it possible to listen to their content while working on my basement. The BP podcast opened my mind to the possibility of investing in real estate. They provided enough insight that I decided to rent this house upon completion of the basement and buy a different primary residence. There’re a few reasons I decided to do this – one of which was the expected returns.
Investment returns on rental real estate come in three forms – cash flow, principal reduction on the mortgage, and appreciation of property values. In my case, I expect the rental property to return about $2,400 in annual cash flow, $3,000 in annual principal reduction, and about $5,000 in annual appreciation. In all, let’s round this down to $10,000/year. This breakdown of investment returns is important because it demonstrates that most of my returns are coming from appreciation and principal reduction. When most people ask about my decision to rent, they ask about the cash flow and the other two components aren’t initially considered. $2,400 hardly seems worth dealing with and people are often perplexed why I’d hassle myself with the inconvenience of managing a rental house for such paltry cash flow. The reality is that cash flow is a drop in the bucket in this case – although a very important aspect of investing in real estate.
The alternative to renting my place was to sell, which would have net me $18,000. The reason this is only $18,000 is because I live in the rural Midwest where the average home value is only $250,000, because I’d have to pay realtor and closing fees, and because I re-leveraged the house before renting to provide working capital for another investment property I acquired. The expected outcome of this rental house is a collective $10,000 annual benefit, and only $18,000 was left in the property, which is an initial 55% return on capital.
My strategy is very similar to the BRRRR method Bigger Pockets advocates for. BRRRR is the process of buying a house, remodeling it, renting it, refinancing it, and repeating the process. In short – buy, rehab, rent, refinance, repeat. The intended outcome of BRRRR is to acquire a cash flowing rental property while leaving the least amount of your money in the deal as possible. Many people initially consider it irresponsible to leave as little equity in a property as possible. You can argue either way on this but at the end of the day, equity in a house does not pay the bills and cash in the bank does. BRRRR is simply choosing cash over equity. Also, you still have skin in the game – the bank will still only allow a 70% – 80% loan to value on an investment property. With the BRRRR strategy you’ve simply cashed in on your sweat equity. For example, let’s say you buy a $100,000 house with a $70,000 mortgage. You then proceed to spend $40,000 in renovations, which brings the value to $200,000. Your total contributions at this point is $70,000 ($30,000 down payment + $40,000 in renovations). With a cash out refinance you should be able to acquire a $140,000 mortgage against the house. After paying off the original $70,000 mortgage you’re left with $70,000 cash-out to refund your contributions. You’re still leveraged 70% on the property value. You still have a property that cash flows. You’ve simply removed your initial investment in exchange for hard work, and now you have cash to pad your bank account or repeat the process.
My future real estate endeavors are not set in stone but my focus for the next few years will be remodeling the new house I purchased. This cost me $178,300 to purchase and after $50,000 of renovations it should be worth $275,000 – $300,000 three years from now, depending how the housing market performs in my neighborhood. There’s a good chance I’ll re-leverage this house like I did for the rental house. I may also sell the rental house within this time to avoid capital gains tax since I’ll have lived in it 2 of the past 5 years. But I’d need to have another investment opportunity lined up because it wouldn’t make sense to sell for the purpose of saving $10,000 – $15,000 in capital gains tax if it meant losing an asset that was providing a $10,000 annual benefit.
Remodeling the rental house is the reason I didn’t put much time into this blog in 2020. I also hold a full-time job and have a few very young children so any remodeling is done before and after work hours. I do hope though to post a little more frequently in 2021.