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A Winning Combination

Posted on May 6, 2014

“Happiness is a positive cash flow.” - Fred Adler

This will be our third post in a three week series on real estate investing. In the first post entitled Home Sweet Home we looked at why a personal residence should be considered more of a savings vehicle than a substitute for a well-diversified investment portfolio. Then we compared the cost of owning a house versus renting one in our second post entitled To Own Or Not To Own?. This week we move beyond the personal residence and look at investment properties that can not only capture appreciation but also produce cash flow from rents..

As Fred Adler, venture capitalist and director of Forbes, aptly stated in the opening quote, “happiness is a positive cash flow.” Many retirees that are currently living off of their savings can vouch for this statement. Even though it is always best to look at an investment from a total return perspective, there is something comforting about receiving an income stream from an investment in the form of interest, dividends, or in the case of real estate, rental payments. The ability to rent a property out to cover expenses and potentially even produce positive cash flow is the difference maker when it comes to looking at real estate as a good investment.

To prove this point, we will again go back to the example we’ve been using the past couple weeks of a $250,000 house that can be rented at a gross cap rate of 6 over a 30 year time horizon. As a quick review, a “cap rate” is a measure of the yield on a real estate investment, so a 6 cap on a $250k property means it can kick off $15,000 a year in rent ($250,000 * 6% = $15,000). In this example the $15,000 a year would be considered a gross number as there are a number of things including taxes, maintenance, insurance, property management fees, and vacancies which reduce this number down to what we will call “net rent.” The table below summarizes the inputs and assumptions used in this example. As a review, most of these assumptions were arrived at by scouring the web to find average historical values for each input.

2014-05-06_Assumption_Table.png

First let’s look at what we will call the Dave Ramsey example where a house is purchased outright in cash and rented for 30 years under our predefined assumptions. In this scenario, the annual return on investment over the entire 30 year period ends up being 6.4%. Stripping out the effects of inflation brings the real return on investment down to 3.1% a year. To put this number in perspective, real rates of return on US stocks and bonds have averaged around 7% and 2.5% over the past 100 years, so a 3% real rate of return is not bad for an asset that can also add a meaningful amount of diversification to a stock-bond portfolio.

For those that either don’t have $250k in the bank to buy a house outright or aren’t afraid of using a prudent amount of leverage, a mortgage can be used to purchase an investment property. If we keep all of the same assumptions from the first example, but only put 30% down with a 5.0% fixed 30-year mortgage, our immediate cash flow picture isn’t as nice. This might make Fred Alder sad, but the long-term rates of return are actually improved. Under this scenario, the annual return on investment increases to 7.2% or a 3.9% real rate of return above inflation. The property must be carried for the first 13 years until it turns cash flow positive in year 14, as shown in the very busy chart below outlining inflation adjusted cash flows and asset values for the two different scenarios. All else equal, everyone would prefer the black bar (all cash) return stream to the green bar (leveraged) stream, but keep in mind that the all cash stream required an initial outlay of over $250k while the leveraged return stream only needed around $75k. Even though the return streams look quite different, they both end up in the same spot after the 30 year mortgage has been paid off.

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The only reason using a mortgage improved the total return numbers versus the all cash scenario is because the cost of the mortgage (5.0%) was less than the total return on the investment, which is being driven by appreciation (3.7%) and net rents (2.9%). The wider the spread between the cost of leverage and the return on investment, the more a prudent amount of leverage makes sense for an investor. As an example, if we assume the house can be rented at a gross cap rate of 7%, which by the way is where my rent currently stands, the real rate of return for the leveraged investor jumps 1.5% from 3.9% to 5.4% whereas it increases by only 0.9% from 3.1% to 4.0% for the all cash investor.

The reason rental properties can be a good investment versus a primary residence is the fact that they have the winning combination of multiple return streams coming from appreciation and rental income. Returns can be further magnified with the prudent use of leverage as long as the cost of the mortgage is below the expected total return on the underlying asset. When a real estate investment is able to deliver not only appreciation but also income in the form of rent, it can be a very valuable addition to a well-diversified portfolio which is why we have continued to rely on it in our Diversification 2.0 portfolio construction.


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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