Summary: People often compare real estate to stocks or other investment vehicles but don’t have a clear picture of the magnitude of the return you can get with real estate and more specifically, with cashflowing rentals. In this post, we explore how cashflowing rentals can help you achieve higher returns, that is, assuming you know what you’re doing. This is a strategy that works in any market, whether we’re entering a recession or in a hot market. It is meant for those who want to achieve financial freedom as quickly as possible, something we call Fast FIRE.
[2022 update: This article was originally published in June 2018. We completely revamped this article to reflect all of the experience we have gained from acquiring over 150 units of our own rentals, syndicating another 424 multifamily apartment units and coaching and mentoring over 3,000 doctors and high-income professionals how to achieve Fast FIRE with their own rentals. We have also taken into account the current economic environment with rising inflation and mortgage rates]
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
If you’re just getting started with investing, you’ve probably thought about adding real estate to your investment portfolio.
Maybe your research led you here, and you’re wondering if real estate investing is for you.
If you have doubts, I’m guessing someone planted a seed in your head. Maybe you have a family member or close friend who had a really bad experience with real estate. Or you read an article telling you that owning your own rental properties isn’t worth the effort. Or you saw some ads about the benefits of investing in real estate without all of the hassles. Or someone told you that with everything going on with inflation and interest rates, this is a terrible time to get into real estate and that it’s best to sit on the sidelines.
So how does someone new to real estate figure out how it fits in with all of the other ways to invest? And if you decide to add real estate to your portfolio, how do you decide between buying your own rental properties, investing in turnkey properties or investing passively?
We’d suggest approaching this choice by asking yourself a simple question: “Which form of investing will give me the highest return on investment?”
If you’re looking for high returns with real estate, nothing even comes close to owning your own rentals. In this article, we’re going to show you why.
What do we mean by cashflowing rentals?
Let’s start by defining what we mean by cashflowing rentals.
Rental properties are real estate assets that you rent out. Someone pays you rent in exchange for use of the property. There are many different types of real estate assets. These include single family homes, multifamily, office space, retail space, mobile home parks, storage space, etc.
For the purposes of this article, we’re going to focus on small multifamily properties. These are duplexes, triplexes and fouplexes. A duplex has two separate living units under one roof. A fourplex has four.
A cashflowing rental is a property that rents for more than all of the expenses combined. These expenses include the utilities, property taxes, insurance, property management and mortgage to name a few. Cashflow is the money you put in your pocket at the end of each month after paying for all of these expenses.
Actions you’ll need to take in order to maximize your return
If you want to achieve high returns from cashflowing rentals, you’ll need to implement a collection of actions at the same time. If you choose to forgo any of these actions, you’ll likely achieve lower returns. If you implement all of them together, then your chances of achieving a high level of return goes up significantly.
Action 4: Achieve real estate professional status (REPS) as quickly as possible and maximize tax savings using cost segregation/bonus depreciation. Or if REPS isn’t an option, take advantage of the short-term rental tax loophole to shelter W2 or 1099 income.
Action 5: Use leverage to acquire as many properties as possible. Also, find ways to lower your down payment to preserve cash. For example, you can buy a short-term rental with only 10% down. You can also house hack and use a 3.5% FHA loan or a low money down doctor loan.
Action 6: Reinvest all of your cashflow and tax savings in order to take advantage of the power of compounding.
Action 7: Take advantage of a rapidly appreciating property in your portfolio by selling it and reinvesting all of the proceeds tax-free using a 1031 exchange or doing a cash-out refinance and reinvesting the proceeds.
How does the return from cashflowing rentals compare to other forms of real estate investing?
When you implement all of the aforementioned strategies, you can achieve a return ranging from 35% to over 200%.
How does this compare to other forms of real estate investing?
Probably the closest thing to cashflowing rentals is a turnkey rental.
A turnkey rental, according to Investopedia, is a “a fully renovated home or apartment building that an investor can purchase and immediately rent out.”
The upside of a turnkey rental is that you minimize the upfront work required to buy and renovate the property. However, the downside is that you miss out on immediate and forced appreciation. As mentioned above, forced appreciation is one of the biggest components of return, so when you give this up, your overall return drops significantly.
Many of the other forms of real estate investing, such as crowdfunding, real estate investment trusts (REITs) and real estate syndications, are passive. The yield on passive investments is considerably lower. They might range from 7 to 15% on average. Nowhere near the 35% to over 200% returns you can get with cashflowing rentals. The other downside of these investments is that you can’t take advantage of REPS or the short-term rental tax loophole to shelter your W2 or 1099 income. So you miss out on another big component of return.
How do you get such high returns from cashflowing rentals?
As mentioned above, you can achieve high returns from cashflowing rentals when you implement all of the actions in combination.
Since there are so many moving parts and so many different actions, we created a financial model to figure out the return on investment.
The financial model
We created a 10-year financial model, which enabled us to take into account multiple changing variables over time. For example, our model assumes 2.5% in rent appreciation each year. When rents increase, multiple expense line items such as leasing costs, vacancy and maintenance costs go up as well.
The model also enables us to look over a 10-year period and average the return over that time period. Most models only look at the return for the first year and fail to take into account future years. You can’t ignore future years because variables such as tax savings and compound interest change dramatically over time.
For this model, we assume that you own 4 duplexes (8 units), each purchased for $165,000. This is a total investment of about $45,000 (down payment plus minor repairs and closing costs) per property. Our model also uses actual rents and expenses from our duplexes.
One of the keys to achieving higher returns is the tax benefits of claiming real estate professional status. In order to maximize your returns with real estate professional status, we recommend that you 1) renovate your properties in the early years and 2) use cost segregation to maximize your depreciation expense. Therefore, for the model, we assumed that you spend about $10,000/year over the first five years for repairs to each of your properties. This is a very conservative assumption because this assumes 0% bonus depreciation. Currently there is something called 100% bonus depreciation, but this is being phased out to 0% over the next 4 years. In terms of cost segregation, we assume that you allocate 30% of the building value for cost segregation and that you depreciate this portion over 5 years.
The return on investment is then derived by adding up the return from five sources. These are the cashflow from your property + the equity you build up with each mortgage payment + tax savings + forced appreciation + compound interest you receive when you reinvest the cashflow and tax savings.
The components of return
This is the most straightforward because it is based on the assumption that you only purchase properties that generate 10% cash-on-cash (COC) return. Many believe that you can’t find properties that generate this level of return in the current market, but it is not impossible, especially if you buy properties that are under-rented or have hidden value. Most of our current properties are getting above this level of return, with one of our duplexes generating 40% COC return.
Download our free COC Return Calculator to analyze your rental properties!
This is also fairly straightforward but requires you to make assumptions about the interest rate and amortization period. In our model, we assumed a 6% interest rate and a 30-year amortization period. This takes into account the current high mortgage rate environment. We then added up the equity you accumulate over a year and divided this amount by the total investment. We did the same calculation over 10 years. Then, we averaged the return over the 10 years to come up with 3%.
Tax savings (1%)
This is a more complicated calculation because the degree of tax savings depends on your expenses and in particular, phantom expenses and repairs.
Phantom expenses were covered in a previous article, but, in brief, they are expenses that you don’t actually pay for but the IRS allows you to claim. These include things like depreciation, phone/internet bills, and home office expense. You already paid for these for personal use, but you are allocating half of the bill for your real estate business.
For the purposes of this analysis, we assumed that you use cost segregation to further increase the amount you depreciate.
In terms of repairs, we assumed that you spend $10,000 in repairs a year for the first five years.
As a Real Estate Professional, you can deduct losses from your property from your clinical income. The amount that you save in taxes is money in your pocket. The reason the tax savings is only 1% is that the tax savings are considerably less in the last 5 years. You stop spending money on repairs, and you’ve fully depreciated the portion that was cost segregated. In fact, in this model, the return from tax savings in the first year is 10%, then goes down to 8% the second year. The reason for front-loading your tax savings is to take advantage of the power of compound interest (covered in the next section).
Immediate and forced appreciation (varies significantly but ranges from 10% to over 200%)
This is by far the biggest component of return. This is based on the amount your property appreciates. One reason it’s so large is that the appreciation is based on the value of the property, not the amount you invest. For investment properties, you typically put down 25% and borrow 75%. When the property appreciates, you get to keep all of the appreciation. The bank gets none of it. For example, if a $200,000 property appreciates by 20%, the property has appreciated $40,000. To buy this property, you only had to put down $50,000. So you’ve now made 80% return on your investment just from appreciation.
Now you can do even better than 80% return if you negotiate some seller credits and decrease your down payment. Let’s assume that in the example above, you negotiate a $10,000 seller credit at closing. This means that you now only need to put down $40,000 instead of $50,000. In this scenario, when the property appreciates by $40,000, your return is now 100%.
In the model, we used some conservative assumptions to come up with a range of 10% to 200%. On the low end, we assumed zero immediate appreciation and only a small amount of forced appreciation. On the high end, we assumed some immediate appreciation and more forced appreciation. You can see from the example above, that the combination of immediate appreciation and forced appreciation drives up the return significantly.
Compound interest (11%)
When you reinvest all of your cashflow and tax savings, you make interest on this money. As time goes on, this interest becomes very significant. As described above, we front-load these tax savings by making repairs to the properties and using cost segregation. This gives time for your money to grow through compounding. In our model, we assumed you reinvest all of your cashflow and tax savings. If you don’t reinvest it all, you’ll get a lower return. This might happen if you use some of the cashflow for personal use.
How do you generate even higher returns?
While the 35% to over 200% return is significant on its own, you can actually get even higher returns.
You can do this with 1031 exchanges or cash-out refis to grow your portfolio tax deferred. This is how we traded in three smaller properties to buy a $3 million, 32 unit property.
Cash-out refinances are another way to grow your portfolio using the equity you’ve built up in your property. When you use a combination of immediate and forced appreciation, this equity can build up quickly. You don’t have to wait the years it takes to pay down your loans. Instead, you can build up enough equity to cash-out some of it out in less than 3 to 6 months after you purchased the property.
We did not include 1031 exchanges or cash-out refinances in our model because it added complexity to the model and we figured it’s probably enough for people to know that you can get even higher returns if you layer in these additional strategies to your rental property investing.
Is investing in rental properties right for you?
We can understand if you have doubts. There are so many gurus out there telling you that investing should be boring or rentals are too much hassle.
Instead of being influenced, start with YOUR goals. Don’t let someone else decide for you.
If your goal is to achieve Fast FIRE (financial freedom while you’re young enough to enjoy it), then you’ll want an investing strategy that gives you the highest return.
But keep in mind that there’s no right or wrong way to invest. It comes down to what’s most important to you. For some, that is passive real estate investing. If that’s something you’re interested in, we have a lot of resources available for you to learn more about the different options that are available. If that’s something you’re interested in, check out our guide to passive real estate investing.
Is there anything missing from this strategy? How many of the components have you incorporated into your own real estate investing? What type of returns have you achieved? Please tell us in the comments below!
Interested in learning more about how to build a portfolio of cashflowing real estate? Be part of the conversation! Follow our general Semi-Retired MD Facebook page and then join our physicians or professionals group!
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