A Quick Market Newsletter

A short post tonight.  Here is a link to a useful free financial newsletter from Axiom Financial.  The format has remained the same for several years and provides a quick weekly update of market conditions.

http://www.axiomfinancial.com/market-watch

Image from Axiom Financial

Image from Axiom Financial

 

Cash on Cash Returns for Rental Properties

Financial Place Online test fired their “Complete Landlord Calculator” today.  The first test involved what is referred to as “Cash on Cash” return.  The “Cash on Cash” return is the percentage of annual cash received vs your initial investment.  This is an important return as it defines how your investment cash flow looks.  A negative return indicates that the house is sucking up money.  Higher positive returns can be had with better management of the underlying financials such as interest rate, purchase price, and rent received.  A higher rate can also be had by increasing the amount of leverage of your investment capital.

Leverage of Capital:  The ratio between your invested capital and the purchase price of the asset.  In the case of a $50,000 investment and a $50,000 purchase price, the leverage is 1:1, or more simply expressed as 1.  However, if the investment was $5,000 for the same $50,000 asset as would be done through using the bank’s money to cover the other $45,000, the leverage would be 10.  A higher leverage will return a higher rate of return for investments who return a rate greater than the weighted averaged cost of borrowing.

The problem with using leverage is that negative returns get exaggerated in the same way.  This deals with both cash flows and a decrease in value of the underlying asset.  Using the $50,000 asset with a leverage of 10, a $5,000 drop in value wipes out all of your investment, since the bank still needs to be paid.  In most all cases, the bank has secured the loan by your asset, so they will be the first to be paid in case you have to sell.

The below chart shows an example case of “Cash on Cash” returns plotted against the amount invested.  The investment being examined has the following characteristics:

  1. This is a house priced at $150,000
  2. Your out of pocket closing costs are $1,500
  3. The mortgage is for a 30 year term
  4. The interest rate is 4%
  5. The rents collected is $1200
  6. Property management takes 10% of rents collected
  7. Occupancy rate is 95%.  Many rental markets are on fire right now
  8. Property taxes at $1500 per year
  9. Hazard insurance is $300 per year

Cash on Cash>>> The chart shows a very high rate of return in the case of 0% down (just the $1,500 closing costs).  From here the rate of return decays exponentially until it flattens near 6.5%.  This amount is the unleveraged rate of return.  Again, remember that too much leverage can be dangerous.  In the case of residential real estate, a healthy amount of leverage can be had between 10% and 30%, and will vary from opportunity to opportunity.  There was entirely too much dealing done during the sub prime era of real estate lending where 0% down deals were permitted on rental properties.  The highly leveraged cash flows swung to the negative after the crash and many investors did not have the cash on hand (which is why they did 0% down) to cover the losses, and thus lost their businesses.

 

How to earn an extra $500 a month: Part 1

dollars_and_centsThe concept of wealth creation at Financial Place Online is that it is a process of thrift and continuous improvement, measured over a long period of time, perhaps even over generations.  There has to be a starting point somewhere, and $500 extra income a month meets the needs of many.  The 2012 U.S. median income was just a little over $50k.  Certainly, an extra 12% is achievable, and given the U.S. median savings rate of 4%, the extra $6k per year would quadruple the median amount of disposable income if the right tax management is done to compensate.

How is $500 extra a month best earned?  Any way that it can be.  Below is a list created by FPO with investment methods to create this extra cash flow.  None of them are easy, but they are achievable.

  • If you’re 65 years old – buying the $100k annuity from our annuity example would generate $521 per month for the rest of your life.  The amount is more if you’re over 65, and less if under.
  • The Vanguard Total Bond Market Fund (VBMFX), has earned a 10-year average of 5%.  $120k invested here $500 per month.
  • It is common to see entry level houses rent for about 1% of the purchase price per month.  Paying cash for a $70,000 house would net a $500 per month extra after property management fees and repairs.  Don’t count too much on appreciation at this time.
  • Based on the 10-year return of the Vanguard Total Stock Market Fund (VTSMX), the $500 per month can be generated from an initial investment of $60,000.

This is good in theory, but the issue in the above is that there is a lot of upfront cash required.  There are two things wrong here.  One is that the cash may not be available.  The second is that each of these opportunities return less than 8%.  That’s not the smartest way to tie up cash.  Part 2 of this article will explain when it’s suitable to use the bank’s money to get a higher rate of return.

House purchasing economies of scale

This one is a quick reminder for those attracted to investment properties. The right home to have for the purpose of renting out will be around the price median for a given area. Too expensive of a home, and it will be hard to get what is needed in monthly rent. The exceptions being vacation homes, and the luxury market.

The other end of the spectrum is even more problematic. A $40k house will have many cost items that are the same as a $160k house. Here is a list for example:

Appraisal: $200-$400. The house size can influence price, but not by much.

Home Inspection: $200-$500 depending on tests performed. It is similar to appraisal, but can vary a little more with house size. Most of the inspection will be a fixed cost.

Plumbing: Trip fees and simple fixes will be the same. Toilets will be the same.

Mortgages and titling fees generally disregard house size.

Cable TV, and utility service fees will be the same

Evictions will cost the same

Liability issues will be roughly the same

While this list has exceptions, its purpose is to provoke thought about the “good deals” to be had in low cost houses. Always make sure to do your own due diligence before making any kind of investment, and if unsure…consult a local professional advisor.

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