Real estate is a wonderful way to invest your money, because of the multiple benefits rental properties offer. I make money on my rentals through cash flow, equity pay down, tax advantages, buying below market value and appreciation. Even though appreciation has increased my net worth a lot over the last five years, I prefer to invest for cash flow. I think long-term cash flow that comes in every month for as long as you own the property beats appreciation every time. Appreciation looks great on paper and will increase your net worth, but will it make you rich? After all, you must sell your properties or refinance them to take advantage of the increased prices.
The idea of appreciation versus cash flow has become very personal to me, because of my current rental property investments. I own 16 rentals, with 15 of them being in Northern Colorado and one being in Cleveland. My properties in Colorado have increased in value since I bought them due to regular appreciation and forced appreciation. Forced appreciation is when you increase the value of a property by making repairs or adding value in another way. I figure I have invested about $350,000 in cash into my rental properties and they have about 1.4 million dollars in equity in them. I bought my first rental in December of 2010, which means I have managed to more than triple my investment in about five years. While I am thrilled with my results, I am also concerned that I am not using the equity in my properties fully. Is the equity in my properties making as much money as it should be?
How much cash flow am I making from my rental properties?
I figure I am making about $7,500 a month from my 15 rentals in Colorado. I will not count the rental in Cleveland, because I bought it with my IRA and it is part of a different strategy. I have spent about $500,000 in cash to buy my 15 rental properties, but I refinanced four of them over the years and have gotten back about $150,000 through those refinances making my total investment about $350,000. If I look at $7,500 a month or $90,000 a year return based off a $350,000 investment that is about a 25 percent cash on cash return. That is an amazing return and many of you may think I am crazy for thinking I could be doing better. If I look at all the cash equity I have in my properties (1.2 million after selling costs), I am only making 7 percent on my money. I may be spoiled, but I want to make a lot more than 7 percent on my investments.
How was I able to increase the equity on my rental properties to over one million dollars?
The Colorado market has done fantastic over the last five years, with prices almost doubling. Colorado has one of the highest appreciating markets in the country, which has been great for my net worth. Appreciation is not the only reason I have so much equity in my rental properties. I also forced appreciation on those properties by purchasing below market and making repairs or improvements.
I purchased rental property number four in 2012 for $109,000. It was a short sale and needed about $15,000 in work. I got a great deal on this home and I figure it was worth at least $160,000 after I made the repairs in 2012. That home was refinanced last year and appraised for $195,000. It is worth over $200,000 now and probably close to $210,000. Here are the gains I have seen:
- $36,000 in forced appreciation and buying below market
- $50,000 in market appreciation
While the increase in market values has been awesome, buying cheap and making repairs was also a big part of the equity gain in my rental properties. Especially when you consider the $36,000 gain was seen immediately and it took over three years to see the $50,000 gain. We also had one of the hottest markets in the country and this was a best case scenario. I think most investors are happy with a 5 percent appreciation rate, in which case I would have seen a $25,000 increase.
Why is appreciation not as great as it appears?
While it looks awesome on paper to have over 1.4 million dollars in equity on my rentals, that is a paper gain. That money is not in my bank account and as I said earlier it is making me about 7 percent interest. If I wanted to access that money I would have to sell or refinance my properties.
- My properties total value is about 2.7 million dollars with about 1.3 million in current debt.
- If I sold my properties and wanted to pocket the cash I would have to pay selling costs, capital gains taxes and taxes on recaptured depreciation.
- If I refinanced I would only be able to get loans on 75 percent of the value of the properties and it will be tough to find a bank that will finance all of my properties considering I have 15 mortgages.
If I wanted to sell my properties it would be a little trick because they are almost all single family rentals. The highest and best use for my rentals would be as single family homes for owner occupants. That means I would need to get the current tenants out and make sure the homes are in great shape. I also would have to pay selling costs which would be about 7 percent for me as a real estate agent and 10 percent for someone who is not an agent.
- Selling costs on my 2.7 million dollars worth of properties would be $189,000 assuming no repairs are needed. I would guess there would be at least $50,000 in repairs needed to get everything in perfect shape. Total cost $239,000.
- Capital gains tax would be 20 percent on my sales because I am in the highest tax bracket. This would be figured on my profit on these properties, not the equity I have. I think my total profit over the years is about $868,000 after paying selling costs. My capital gains tax would be $173,600.
- Recapture of deprecation is another tax I would have to pay. I don’t have the time to figure all the taxes I have saved on depreciation, but I am guessing it is about $50,000.
If I managed to sell my properties I would make about 1.4 million dollars, but have about $462,600 in costs bringing the money I could put in my pocket at under one million dollars. That is about 67 percent of the gain I see on paper. It would also take some time to sell those properties and it may take more in repairs than I estimated as well. If you are simply investing for appreciation, remember that there are many costs associated with selling properties and you will not be making as much as the gain is on paper.
If I were to refinance my properties I could theoretically take out 75 percent of the current value of the homes. That would be just over 2 million dollars, but that assumes the appraisals all come in at value, which is rare on a refinance. I would also have closing costs, which would be around three percent of the loan amounts or $60,000. If I paid off my current debt that would leave me about $600,000 in cash I could take out of my properties. If I did that may payments would be much higher than they are now, because my interest rates would be higher than they are now. It also may be tough financing all of that at once, unless I used a national portfolio lender in which case I would be paying much higher interest rates. With a refinance my debt ratios would increase greatly, my cash flow would decrease greatly and I would be increasing my risk greatly. That assumes a lender would go all the way up to 75 percent loan to value. A refinance would definitely give me cash out, but not nearly as much as my gains are on paper.
Why I am I rethinking my current real estate investing strategy?
I have been very happy with my results so far. $7,500 a month and a 1.4 million dollar gain on paper is not bad from a $350,000 investment spread out over five years. As you can see the appreciation gain is not as much as it appears to be, but the cash flow is actually better than it appears, because of the tax advantages rental properties have. I still think I could be taking advantage of the current equity in my rentals. My thought was to sell some of my properties and buy different rentals in a more cash flow friendly market. With prices so high in Colorado it is really tough to find properties that cash flow well and no way I could repeat what I have done in the past.
I recently posed the question of selling and buying in another market on a popular real estate forum. I was blown away at how many people thought I was crazy to think about selling, because they thought my market would keep on appreciating and think of all the appreciation I would miss out on by selling. You can comment on this article and tell me if I am crazy as well, but here are my thoughts.
- Much of my gains and cash flow was created from buying below market and making repairs.
- 1.4 million dollars in equity is a lot to have tied up, making 7 percent interest.
- If I could use the current equity to repeat what I have done in another market I could supercharge my portfolio and jump forward toward my goal to purchase 100 properties.
The great thing about rentals is you can use a 1031 exchange to pay no taxes on the profit you have made. I could slowly start selling off my rentals that are the worst performers or in less than prime locations and exchange them into new rentals that have great cash flow and were bought below market value.
I have identified 7 rentals I own now that are not in prime areas. I would not sell these all at once, but maybe one at time once the leases expire. Here is an example of a property I might sell:
- Has $108,000 equity after selling costs.
- I would sell it and identify a new property in a new location.
- Pay cash for new property using all the proceeds from selling property and maybe a little more cash from savings.
- Fix up house and rent it.
- Refinance house at 75 percent of appraised value if I can local lender with no seasoning period.
Let’s assume I bought the house for $115,000 and put $10,000 into it for repairs. If it is worth $140,000 after repairs I would get $105,000 proceeds from refinance. The house would cash flow $400 or $500 after refinance, based on my criteria. I can take the $105,000 and buy three more houses using 20 percent down loans with each property cash flowing $400 or $500 a month.
In the end my current rental making $500 a month in Colorado will buy me 4 new rentals somewhere else with cash flow $1,600 to $2,000 a month. Because I bought all four houses below market and added value through repairs, I will have gained at least $80,000 in instant equity. My $108,000 plus $17,000 of my own cash has turned into over $200,000 in equity. Not only am I increasing cash flow, I am increasing net worth. That was from just one house. If I rinse and repeat this process I can turn 4 houses into almost as much cash flow as I am making now with 15. Plus I gain over $350,000 in equity.
There is obviously risk investing in a new market, but I could sit back and relax hoping for more appreciation that I can’t really use or I could do what has made me the most money in the past and reinvest my equity into new properties.
Hopefully you made it through all that math and the number made sense. I just thought of this idea a few days ago and I am slowly working through what it would take and if it would be worth it. I think if I could find an awesome market it would definitively be worth the risk and work. Hopefully this article showed that while appreciation can be an awesome tool to use, by itself it is not as great as many make it out to be.
One more thing. I have having another webinar on rental properties next week and you can register here. I will be taking live questions!