I was a guest on the Joe Fairless Podcast, how I got started, and a bit about turnkeys and trench drains
Learn how/why I got out my high priced Seattle (Appreciation) market and into 9 Properties In 5 Months Via 1031 Exchange
Today ends a 9 property, 5 month, buying spree that started back in October 2015 with the sale of my subject Seattle portfolio. I did not know what to call these shenanigans and simply calling it a 1031 did not do it justice. Therefore I will name this feat a “1031-O-Rama” which is inspired by the good old 2008 days where one could apply for a bunch of credit cards with 0% interest. All of you are Real Estate investors and sticking money into a high-interest rewards checking account is kiddie stuff so if you’re ready to go gangbusters here we go…
From 2010-2015, my rentals in Seattle were cash flowing each with 400-600 a month (after vacancy/capex/repairs…), but it was because I bought these properties at the right time so when I tried to buy again in 2015 or early as 2012, prices would not cashflow with typical 20% down financing. My rentals were A+ class and were below the 0.5% Rent to Value Ratio… so amateur, I know. I think everyone would agree that like SF, Seattle has seen great appreciation over the past few years due to the influx of foreign money and tech companies. As a real estate investor you need to always be looking at the numbers and in this case the Return of Deployable Equity (ROE=your sales price minus commissions minus current mortgage balance). By sitting on so much “Lazy Money” in the form of equity I was making less than 5 percent in terms of ROE (The IRR metric is when you buy, the ROE is to evaluate the performance once you are in operation). If the ROE is less than 8 percent/year you are better off in the stock market even though I am not a fan of stocks/mutual funds. Let’s face it, rentals have some risks such as unexpected capital expenses, legal liability, and the low level of overall “PITA” (Pain in the butt). Since 5% < 8%, I needed to re-position my money. Now if this were a Las Vegas movie (funny how appreciation is like gambling) I would be grabbing my chips from the craps table, cashing out at the money cage, and retreating up to my room with my winnings and a beer/pizza.
In the end, I traded two properties via two 1031s that cash flowed a total of $1,000 a month for 10 properties that cash flowed over $3,000 a month (after expenses, vacancy, turn over, capital expenses, and property management). Now I beckon the recession to come because I have more than enough buffer in each individual rental to lower my rents by a couple hundred dollars and since pay the mortgage. A mentor of mine told me that the risk is not the interest rate or amount of debt but the lack of buffer in the spread between your rent, expenses, and mortgage.
Throughout the lending process, I know there must be clones of me with all the DNA samples the lenders/underwriters needed from me (well not really) but it’s a huge PITA to go through the Fannie Mae loan process and execute on multiple loans.You think Fannie loan #1-4 is tough, #5-10 is another level. At any one time I had parallel processes of purchases sale agreements pending, inspections, re-negotiation, inspection punch list, property management interviews and setup, contractor logistics, etc. What a mess. A lot of lenders will recommend that you cross-collateralize your investments so you can get more Fannie Mae loan (max as of now is 10) but I don’t think it should be used in all situations. Remember that loan guy gets paid whenever you originate a loan so of course they are going to recommend it. Also the Fannie Mae loans aren’t really that much better than a portfolio loan…just saying (I can expand on this later in a different article).
On a couple of the properties (#6 of 9 and #9 of 9) I actually didn’t really want them because of things I found in the due-diligence process but I had to close because they were on my “45-day Identified Property List”. I could walk from the deal, but I would have to pay taxes on my unused 1031 funds. The business decision was that it was better to overpay by $6,000 and get the property than have no property and pay the government 25% of $30,000. If you are considering this madness, try not to let your sellers know what you are doing because I got bamboozled by sellers since they knew I had nothing else on my 45-day list of potential properties and HAD to close.
People say that the 180-day deadline is difficult but I would argue that only being able to purchase properties off your 45 day list (period after your subject property closes) is the biggest hurdle and should be really pondered over. A good best practice is to line up your purchase and sale agreement for new acquisition(s) when you are 1-2 weeks before your scheduled closing date so when that date comes…boom you have 5 purchase and sale agreements executed and you are off and running on 45 day closes.
Who did I buy from? I can write about this later in more detail on my site but I had to work with 4 agents/turnkey providers. But here is where I bought one in 2014 and basically had my proof of concept before I went balls to the wall on this stuff.
Now I am so relieved to be out of the roller coaster high appreciation Seattle market and in boring appreciation markets. I know that a few years from now someone will read this note that Seattle properties have gone up 2x in value. However, I’m totally content with my passive cashflow portfolio AKA just chillin’ with my yes… that beer and pizza back in the hotel room watching the movie “The Big Short”.
PS: Now I know a lot of folks will say that I have bought lukewarm deals and yea I agree. But all I know is that it’s a lot better than the stock market and they were good deals for a passive investor/level of effort to obtain them not being an active investor. Other side notes.
Also a link to more 1031 exchange tips and tricks.
If you are holding deals close to your chest or not giving to your so-called competitors. You need to operate with an Abundance Mindset. Plus it’s no fun to do this on your own.
Why the heck are we talking about, a board game?
When people in the very final stages of their life were asked, “what they regretted,” the response that often came up was that they wished they ‘played’ more. (Also in the top responses was a regret of spending so much time at work) The point is, although we are making investments and working hard, we should not forget to ‘play’ or have fun. I had a friend that played hours of video game baseball. Other than the fact that nobody plays baseball on video games, I always gave him crap. Now a little wiser, I realize that he was right… it made him happy and that was important (Side note: I do not condone mindless World of Warcraft addictions). Read on for the second lesson from this board game.
For the past decade, one award-winning board game called “Settlers of Catan”, has built up a huge, cult-like following, garnering hundreds of 5-Star reviews on Amazon and played by normal people unlike the Magic Gathering Card game or Dungeons and Dragons. In other words, females play this game and guys, who could probably save their lives by throwing a football play it too. If you have not heard of this game then you probably have never heard of BiggerPockets.com and you live under a rock. The strategy-intensive game, is intended to last less than 45 minutes. During that time, players collect resources and use them to build roads, settlements, and cities on their way to victory.
Check out this well made 4 minute documentary on the game.
The board game presents players with many decisions that parallel those facing many experienced real estate investors. In Settlers of Catan, there are 5 resources which include sheep, lumber, ore, brick, and grain. In the beginning of the game, sheep and wood are sought after, whereas in the dramatic ending of the game, ore is needed to lock in a win. Side note – I actually have a t-shirt that says “Nobody wants your F-ing Sheep” because as a typical occurrence in every game there is always one unfortunate player who is lagging behind and still trying to peddle their surplus of sheep.
The life cycle of an investor starts with typical equity building with rentals that utilize leverage (sheep/wood) and progress to larger deals (brick/grain). As the investor reaches the second half of their progression and surpassed the “critical point” where they have amassed enough equity build-up to live off their “dividends,” the investor will look to convert their portfolio to a more cash flowing portfolio via de-leveraged rentals, private lending, or notes (ore in Settlers of Catan). This stage is often called the end-game strategy. So often I see newbie investors with low cashflow/low assets with shiny object syndrome and want to get into notes or land contracts because that happened to be what Guru seminar they attended.
So if you don’t care about this fricking game and skipped ahead to the conclusion here it is. Whatever path you take in investing keep the end in mind… the end game… the goal. Have a series of if/then exit strategies in mind with everything you invest in. A few examples:
- A lot of people talk to me and say that they are tired of investing for appreciation and want to go for 100% cashflow to hold on to indefinitely. Having a few years of experience I realize that nothing is forever and things happen. Those investments that you bought, might have gone up in value 20% and it makes sense to cash out or you find another investment that is so much sweeter. But at the time of purchase, you did not think of these potential decisions when you bought the low 40k homes or a duplex/triplex/quad that are inherently harder to sell to a retail buyer as your exit strategy. Perhaps buying a higher price single family home would have been a better way to go (forgoing optimum cashflow).
- You have that meeting with a lawyer who sells you on this elaborate corporate structure but it might be a bit overkill since your dreams of building a 50 home portfolio transitions to other investments.
- You waste your time and money creating a small network of contractors to serve as part-time staff to service your 3 duplexes in the area. However, now it looks like you should sell and you wasted all that sweat equity in creating that system.
- You heard about the wonders of the Self-Directed IRA from a local Real Estate meeting and rush out to make the conversion and deploy your cash into a Real Estate notes. Now you realize that you have lost your leveraging ability but more importantly you are unable to use your IRA as cash reserves to get Fannie Mae loans.
SPC Git Er’ Done Action Plan:
- Don’t let this article give you an excuse for analysis paralysis, but inspire you to find that mentor who can help. You will never know all there needs to know by yourself.
- If you have implemented your Real Estate plan and looking for something fun to do, go out and enjoy life and buy this game! (Help support the site buy via Amazon affiliate link)
A lot of people have been asking for an expose’ of the turnkey investing world, so and here it is. Remember, buying the property is only part of the battle, but efficient operation and systems are what make it work. So please subscribe for good times and stories with SimplePassiveCashflow.com!
Passive Versus Active Investing
Turnkey Investing Defined
Turnkey investing is a form of passive investing. The definition of turnkey (TK) investing at the very least is buying a property from a seller called the Turnkey Provider (TKP) that is rent ready. The TKP typically does a rehab of the major components (roof, floor, plumbing, electrical, paint with sturdy tenant grade materials, such as no carpet, no garbage disposals, laminate flooring. etc). The TKP may purchase these at a discount with a part of their company made up of wholesalers or auction buyers to buy the properties at a discount. Also, the TKP may have property management in-house to manage it for a fee after the sale is complete. The TKP may fill the property with a tenant prior to closing the sale – although this verifies the market rents, there is no safeguard that prevents the TKP to just sticking a warm body in there. A lot of buyers like the fact that the TKP is vertically integrated because if the property does not perform you know who to go after. I personally don’t see the advantage of having a vertically integrated TKP as a clear-cut benefit since it brings up the potential for conflicts of interest. For example, if the TKP has a property management side, the property management can cover up shortcomings in the rehab.
“Hey, property management Paul, why is my property getting these 100 dollar repairs like every month?”
“Well, I don’t know it was an excellent rehab (done by my company) so it must be that dang tenant again.” says Paul.
My opinion of “vertically integrated” is that they do everything but also suck at everything… Rather than having a jack of all trades, wouldn’t you want an ace at every position?
How Do I Buy?
In every market (say Birmingham) there are typically two TKPs who are perennial good outfits. And that third TKP seat is constantly being indicted by some sort of FBI investigation… I’m just being funny. But this is where things get tricky from an outsider’s perspective. Who are the good guys and who are the fly by night operations? Good question! My best answer is to use references of disinterested parties – which are different from the uninterested friends/family/negative Nancy’s/nervous Ned’s.
Out of this pain-point, a middle-man layer called the “marketers” have arisen. These are the guys who typically do not live in the local market (most likely California) but do a good job at finding most of the reputable sellers. The marketers put on Meet-ups, podcasts, webinars, troll BiggerPockets, and find buyers who are looking for real estate in their portfolio. The trouble is, they are not doing these services for free, and you as the buyer will pay for it via a markup to the property one way or another. But overall the system works well. The TKP (small company) is good at what they do and are able to focus on finding distressed property and rehabbing. The TKP utilizes the Marketer to sell the inventory and create a profitable business based on volume.
There are some very reputable TKPs out there, but the trouble is sometimes they have so much demand for their product they can charge their buyers (you) a premium price. Pair this with the marketers bringing in lazy money in the form of inexperienced investor itching to get into real estate creates a micro sellers market. Some TKPs have buyer queues where you wait for a property and you have a limited amount to time to buy it or it gets moved on (to the next sucker). These scarce sales tactics are not a place you want to be. Another trick is that a TKP may require you pay cash for a property which basically takes away your ability to do your due-diligence on the property. I always buy with an appraisal contingency and inspection contingency to protect myself. Some will offer guaranteed rents or warranties which are seemingly good but could also mean that the TKP is just buying a $500/year insurance policy so you buy their property and they plan on just using the outside insurance to pay your inevitable claim. I’m going to stop there before I scare folks too much, but these are some of the pitfalls of working directly with the TKP seller (after all Real Estate is their profession).
A lot of folks jump on BiggerPockets and search or post on “Turnkey” and they will get bombarded by vendors being super helpful. I don’t know about you but I have never gone to the bar and been given free beers by other helpful patrons. Well if that’s the feeling you’re getting when you networking on BiggerPockets, make sure you background check who you’re direct messaging with. How are they getting paid? The folks you want to listen to (yes actually have rentals) and merely want to help out another Bro. I’ve used a marketer before but I did not get any value and I will not do it again, especially since it is not hard to find all the reputable sellers with a little bit of digging.
I mentioned two ways to buy a TK (TKP and Marketer) that both have their pros and cons. A third hybrid method that I have employed is to work with a licensed agent that helps you source properties and find your own construction crews to rehab the property. I have mixed opinions about this because it is a bit more work (especially being remote) and the agent is typically ignorant to what components make a good rental. An agent can find you a property that is priced well, however, they will not have the knowledge that an experienced rehabber or TKP will have (sturdy tenant grade materials such as no carpet, no garbage disposals, laminate flooring). So it’s a bit more risk/reward in the end if that’s your cup of tea or should I say Simple Passive Cashflow Latte. What has worked for me is not going with a marketer (due to absurd markup), but using a combination of off-market agents that have a Fiduciary responsibility to represent me and also working directly with the TKP for the best pricing once I had the experience of purchasing 3-5 properties and overpaying along the way.
Why the heck doesn’t the TKP just hold on to the property for themselves?
As stated earlier, the TKP does what they do well. They have the teams and market knowledge to do this efficiently. They could hold on the property but they have chosen to make profits on the volume business since they make their money by managing their multiple crews, essentially they are running a business. If you find a good TKP hopefully you get to partake in some of these efficiencies. But don’t be entitled as a TK buyer. You are not doing any work and frankly you deserve the market rate.
Which class, property value range, would be best to put on the buying list?
This is ultimately up to your investing strategy and criteria. For me to tell you what is the best is irresponsible and against what I believe because you should understand the macro (not micro) concepts for yourself and make your own best individual strategy. With that disclaimer out of the way, I personally went (my strategy changes per my overall portfolio) after B/B+ properties that rented for at least $1000 per month and had at least 3 bed and 2 bath. Some things to think of when finding your strategy/criteria:
- Although I have full intention to hold on to these properties indefinitely for cashflow, recognize that things change and perhaps I might want to trade in 1 “goose that lays the golden egg” for 2 or 3 “geese that lay the golden egg” or 1 “big ass goose that yea you get the point”. To say “I’m making cashflow” is a fallacy… what do the numbers say on the bottom of the spreadsheet and compare the two situations you are evaluating. You should always be making moves to optimize your return assuming it warrants the transaction costs.
- I was using Fannie Mae loans which are those sweet government subsidized 30-year fixed loans. At the time of this writing (5/2016) the most one person can have is 10 to their name. Your plan might be to only get one or two homes and sail off into the sunset but your plan might change and you have to change your plan for the “if” in life. To acquire a conventional Fannie/Freddie non-owner occupied property requires 20-25% down payment. There are also lender costs which I typically estimate at $5000 +/- $1000. Parts of the lender costs are variable such as an origination loan (basically it’s their fee to have to deal with you and headaches you cause them) that is a certain percentage (~1%) of the final loan that changes from lender to lender so this is something you are comparing. Other parts of the lender costs are fixed costs such as inspection costs, credit reports, and appraisal fees. It is these fixed costs that are the same whether you buy a $40K property or a $140K property. This is one reason I personally went after a more expensive property.
- By buying 50K properties that rent for $800 you’re like “Hey that’s awesome that’s a 1.6+% Rent to Value Ratio”. But I suggest reading my article about the nuances of the RV Ratio and property classes.
- Remember the goal is to maximize the profit which is the rent minus expenses. Folks get wrapped around all these metrics but do not forget the goal.
- This is totally my strategy but please think for yourself: When I was getting started I went for the higher priced properties (Not the A properties cause there is no cashflow in those). I went for properties that rent for 1100 that I could get for 100K. I would say these were B+ properties (Note: do not take the seller’s definition). My strategy was to find low hassle properties that had better tenants and properties that I could easily liquidate because they were close to the median home. There is a bit contradiction here because yes they were safer in terms of tenant quality and exit strategy but the cashflow buffer was less so I had less ability to lower rents in a market downturn. Now that I have a stronger base in terms of teams, money, and knowledge I try to go for more C properties because I feel I have the experience and risk tolerance for it (although I stated that these could be safer in terms of the buffer in the cashflow).
I am selling my home for 600k, I want to invest out of state for cash flow 200/month cash each door?
Before you do anything make sure TK investing is for you don’t just jump in cause I like it. However, I think that your per door $200 assumption is in line. There is a difference if you are buying $60K properties or $120K properties but either way, I think you will be beating the averages of the stock market and that is why I do what I do.
This is how it is going to work if you choose to sell and do a 1031 exchange. First, you sell the home for $600k (~10% will go to commissions etc) so you are left with $540K. This is how much you have to acquire or there are tax penalties so if you are looking at $90K properties you are going to need to pick up 6 of them. Your cash in your 1031 will be $540k minus your remaining mortgage. You can bring cash out of pocket to make up any shortcomings. Check out this article for more info on some 1031 issues and strategies.
Other Passive Investing options (REITS & Crowdfunding):
Passive turnkey (TK) investing is a slow way to building long term wealth. My track record in the macro sense is to put down $30K to control a $100K property that rents for a tad over $1000 a month. From that $30K down, I create about $200-300 a month in cashflow or $3000 a year per property. If those of you at home are plotting the day when you leave your job and take over the world, 20 homes would get you about $60K in passive income a year (tax-free) which would require about $300k of down payments.
A lot of smart people dabble in REITs or Crowdfunding deals, but typically it is the operator taking most of the profits off the top. Ideally, if you have the ability to, you want to be in control and be the operator if the numbers make sense. REITs and Crowdfunding deals are just like stock/mutual funds- you do not own the hard asset, and you are at the mercy of the operator to run it like a business and not take business trips to Las Vegas “Conventions” as a business expense. Moreover, most of the time, you also miss out on the tax benefits, such as depreciation. Isn’t this the reason why you want out of the stock/mutual funds in the first place? Plus who the heck knows how Stocks are priced? As if that wasn’t enough, most crowdfunding platforms (at least for now) require that you be an accredited investor. Most of you starting out won’t qualify.
Here are a few of links with actual portfolio analysis of these Crowdfunding methods in action:
Why go through all this trouble of a rental?
As in the above Crowdfunding links, the returns range from 6-12%. These returns suck. I mean it’s good for an institutional investor or someone with a gazillion dollars, however, I look for cash-on-cash returns of ~10% and total gains, or IRR (Internal Rate of Return), of ~20-40% per year.
For my info on total gains see this article: How We Make Money with Real Estate & the Hidden Returns
Here are some questions I often receive from readers:
- Are you visiting these locations at any frequency and for the initial purchases, or are you able to have enough trust and working relationship with other professional resources at those locations?
- I’m interested in a few out of state markets while trying to better understand what acquisition and management options are realistic. Ideally, I’d prefer not to travel.
- Hey, can you help me get started? Can you give me your providers?
I could do that, but that would be doing you a huge disservice because you will not be properly educated. Use these people as your educators.
Here is what I would do:
Find at least 6-10 turnkey dealers via googling turnkey rentals. You can also look online at Bigger Pockets, as many, though not all, turnkey companies have a presence there. Call each and every one of them, and get a dialogue going. Then, ask them the following questions (but not all of them… don’t be a machine, build a relationship:
- Can you break down the structure of your company for me?
- Tell me how your process works from start to finish.
- What does “turnkey” mean with your company?
- Will there be a tenant in place before I close on the property?
- Can I use the financing to purchase the property?
- Do you own properties close to the one you’re selling to me?
- Is the home required to pass inspection and appraisal before I close?
- Can I hire my own appraiser before closing on the property?
- Do you use other companies to help you provide turnkey properties?
- What is your role in the sale of the turnkey properties?
- Who owns the homes?
- Who rehabs the homes?
- Am I expected to pay for the rehab?
- Who are the “boots on the ground” in these areas? Are you talking to the actual guy who manages the crews or just their sales person who never leaves the
- Who manages the properties after the sale?
- How long have you been in business for?
- Is their a warranty on the property after the sale?
- Can I see a scope of work with expenses for one of your rehabs?
- How many properties are generally in your inventory month by month? (The more properties means better economies of scale but can also mean more bloat and more competition from other buyers)
- What sets you apart from other turnkey companies?
- What are some mistakes you make when you started out, and how are you doing those things differently now?
Why Screw Around with Rental Real Estate when I can just do REITS and those really cool crowdfunding sites? Because these REITs are middle men. Work directly!
The Biggest Kept Secret – Hidden Returns of Rental Real Estate
SPC Git Er’ Done Action Plan:
- Sit down, take 10 minutes, and create 60 day action plan.
- If you are a bit overwhelmed I made a simple Excel Gantt chart showing the steps to purchase a property with all the due diligent checklists. I’d like to share it, so take a screenshot of your itunes review and email me with your 60 day action plan and “Gantt Chart” in the subject line. [email protected]
Check out the updated list here.
I promised real life properties and updates and here is the first one. For obvious reasons, the address will not be released for the tenant’s privacy but I am renaming the properties with the city name (Birmingham, Alabama) and the corresponding number that it was acquired.
This property was put into service in September of 2014 and was the successful beta test to prove the concept of remote out-of-state investing. I acquired the property from a marketer that makes connections with the rehabbers in certain markets and finds buyers such as myself who are typically located in low price to value ratio locations (this does not necessarily mean high-priced locations) such as California, New York, Hawaii, Seattle, Portland, and basically the coastal areas that all the cool kids what to actually live. Marketers have their place if the buyer is totally clueless but once you purchase a few of these properties the marketer really does not offer much value. The only thing I see that they would offer would be someone to be the bad guy role in a negotiation but many of the marketers are buddy-buddy with the rehabber because of their business relationship and won’t stick their neck out for you. As the buyer, you need to take ownership of the due-diligence process and negotiations because that marketer is not a licenced agent and does not have a fiducial responsibility to you.
“My Rental #4: Birmingham”Continue reading
Warning – Paradigm shift ahead! In the old Caste System people were split up in ranks to keep lower class people from rising up and keep those in power where they are whereas today, money/mindset is the real separator of the masses.
When I first got started in Real Estate investing I was lucky to have a good job and was able to skip right over the wholeselling/birddogging roles and go right into a buy and hold rentals with the conventional 20% down payment. Little did I know that I had just vaulted over about 80% of my local REIA members who had little money and not making any deals. To be in that 80% group was a terrible place not because of the endless books, seminars, training for the wholeselling/birddogging strategy but competition was fierce – imagine the start of a triathlon as the athletes jump into the first stage of competition -the swim, even the best athletes struggle to distance themselves from the pack as the pack pulls and sabotages those who try to distance themselves.
“Mindset of the best Performers”Continue reading
“We are almost paid off our property and cashflowing like crazy!” – an Unsofisticated investor
Don’t take it from me take it from a Forbes article – Three Financial Metrics Investors Must Monitor To Evaluate A Property’s Success
Download the worksheet to calculate the return on your deployable equity.
Wait I thought Seattle/San Francisco was a hot market with double-digit appreciation and an up and coming tech market?!? Return on Equity = Profit (Cashflow) / Total Deployable Equity if your sold (Don’t forget to include selling commissions)
“every month that goes by you are losing $300/month per $25k you have of deployable equity”
As a real estate investor or any investors consider your Return on Equity (ROE) as a means to evaluate the highest and best use for your capital and to be able to make adjustments to your portfolio over time.
The saying “buy and never sell” will work but “buy and evaluate your ROE prudently” will yield high returns and safer capital preservation.
There are many metrics that Investors use to quantify the quality of their investments. COC, ROI, ROE, are to name a few.
Sophisticated investors re-leverage after their return on equity goes down
Cash on Cash Return on Investment (COC Return)
The pre-tax year-end cash flow divided by the actual amount of original investment you have invested.
COC is used to compare your investment with other options excluding factions such as the use of leverage (mortgage), taxes, appreciation over time, and mortgage paydown over time. As time goes along and your investment goes well due to your tenants paying their rent as they should and the home going up in value due to inflation and market appreciation, COC becomes less relevant.
For example, if you purchased a property with $22,500 down payment, $5,000 in closing expenses, and $2,500 for some touch-up paint and new carpet, you are all-in for an original investment of $30,000. If at the end of the first year with your rental property in operation that you are able to profit $10,000 from cash flow after all operational expenses and debt service were paid, your COC return would be $10,000/$30,000 or 33%.
Sophisticated investors compare COC with other investments to determine the highest and best use for their liquidity going into an investment whereas ROE is used once the investment is owned. COC for mutual fund and stock investments have been known to have been in the 8-10% COC range.
Annualized Return on Investment (Annualized Return)
Annualized return is used to evaluate an investment’s performance over time. Real estate is not a get rich scheme and many times if rehab is done to the property it will require a few years to complete the construction and stabilize the rents for the next buyer to feel comfortable and pay a higher price for the investment.
Annualized return takes into account the cash flow returns received during the hold of the property and the sale or refinances of a property that takes place at the exit. The annualized return is often used to compare syndications (private placements) with different business plans but similar lengths of ownership.
For example, if you received a 8% COC return for 5 years ($8,000 per year on a $100,000 investment for each of 5 years = $40,000). And then you exited the property via a sale at end of year 5 for a gain of $60,000. Your annualized return would be a total of $100,000/5-years or 20% a year. This is calculated with $40,000 in cash flow plus the $60,000 due to the general appreciation of the property.
Return on Equity (ROE)
One of the few downsides of real estate investing is that your investment is illiquid unless you sell or refinance the asset.
As you hold on to investments you are increasing you equity position over time via the following:
- Mortgage paydown
- General appreciation from the market
- Forced appreciation from any property improvements
Say you had a great investment kicking off 20% COC a year. Your return on equity shortly after purchase on a $100,000 home that you used $20,000 to acquire is making you $4,000 profit a year. In this case, your ROE would be 20% ($4,000 divided by $20,000).
But say a couple years go by and with a hot market the property is now worth $160,000. You return of equity on the $160,000 home that you used $20,000 to acquire is now making $5,000 profit a year. In this case, your ROE would be only 6.25% ($5,000 divided by $80,000). Note: This does not include mortgage paydown.
For the minor headaches rental property ownership brings 6.25% would not be worth it. I personally believe that when you ROE dips lower than 10-15% you need to look to make a change in your portfolio via 1) Cash out refinance, 2) 1031 exchange or, 3) simply selling the asset.
There is one intangle metric that we did not talk about here which is your Return on Time (ROT). I don’t believe this is an official term but something that is near and dear to Simple Passive Cashflow Followers. At some point, you need to transition from higher returns and higher headache investments to more scaleable investments where you investing passively.
After purchasing a couple rentals in the Seattle market and being the beneficiary of some nice appreciation, I evaluated the property’s performance with a ROE or Return of Equity metric. On of my rentals had appreciated all the way to $450k and my mortgage that I owned was $200k. Therefore, I had about 250K of “lazy” equity. If you kids are at home with you calculators that 250k goes in the denominator of the calculation. The numerator is the annual cash flow which was about $4K a year. Therefore my return on equity was less than 2%=4k/250k. Frankly, 2% is very poor compared to stocks (~8-10%) or properly leveraged Real Estate (~20-40%).
Calculate how lazy your current rental investments are with this spreadsheet: Link
Video: If your interested in seeing a A-Grade rental in Seattle that does not cashflow (poor cashflow investment)
I am sure someone somewhere is trying to invest in something similar and fooling themselves that they are making money on the project. But you are smart and you subscribe via RSS feed to this blog and podcast 😉
Long story short, I decided to sell these rentals to unleash this “lazy money” and get it working again with prudent leverage. This is what separates sophisticated investors who look at the numbers and your mom & pop investors who go by warm & fuzzy feelings of “hey I’m making cashflow, life is good”. Yes, Mom you are cashflowing but that is because you are halfway to 100% cash in the deal and you are taking on all that hassle and risk for a microscopic return.
A couple graphs for the engineers.
SPC GET ‘ER DONE PLAN:
- Arrange all your properties on a spreadsheet and calculate ROE, Cash on Cash Return, etc.
- Look for the “Lazy Money” to trade in for a better performing investment.