The goal has many different names: retirement, financial freedom, financial independence, to name a few. However, regardless of what you call it, it all comes down to the same thing, people want cash flow to meet their expenses so that they can live life on their terms.
That is a great goal, the question then becomes “How does one get there?”
The important thing to remember is that passive cash flow is not created out of thin air. What I mean is that one typically needs to have a certain amount of equity/assets to produce the needed income. So, the question becomes, “Where do you get the amount of equity/assets to create the cash flow?” Most people’s answer for this is simply to put money in their 401k and hope that those pesky mutual funds finally take off. However, that type of hope has a very low probability of success, so let’s see if there is a better solution.
To find a better solution, we will put together a little case-study. In this study, let’s say that our friend Peppa is starting off with $10,000 in cash today. Let’s assume that Peppa wants to increase her nest egg from $10,000 to $75,000 in 10 years as she believes that with $75,000 she can create the passive cash flow that she wants. We can analyze this with two different scenarios: she invests in mutual funds and she invests in real estate.
Scenario 1: Peppa Invests in Mutual Funds
In this first scenario, Peppa decides that she is going to put her $10,000 into mutual funds. Let’s further assume that those mutual funds grow at the rate of 4% over the next 10 years. That will leave her with a grand total of……$15,000!!! With that she is about $60,000 short of her goal. However, let's play around with the numbers. What would happen if the market took off and her mutual funds increased at a rate of 8%? Well, then she would have only $22,000. What about 12%? Only $33,000!!! None of these scenarios are very good for Peppa. (Keep in mind, the typical rate of growth of mutual funds is closer to the former number than the latter.)
What Rate is Needed?
So, the question becomes, at what rate does $10,000 have to grow to become $75,000 in 10 years? The answer is……….over 20%!!!! This is the point when you say to yourself, “That is ridiculous!! Peppa will never achieve her goal!!” Let's see if you are right.
Herein lies a problem. 20% is a very high rate of return. I do not know of any asset class that consistently produces a 20%+ return over 10 years (for example, real estate’s historical average appreciation is around 4-5%, and the Dow Jones Industrial Average is somewhere around 7-8%).
When people find out that they need such a huge return to grow their nest egg is where things get dangerous. It gets dangerous because that is when people begin to speculate. People start taking very risky investments, disregarding sound investing principles and start pushing the envelope all in the name of chasing crazy yields. For example, I am sure that we have all had (or heard of) that friend approach us who knows a guy who knows another guy who is creating the next Google, but to do so he would need an "investment" from us of $100,000 by tomorrow, but don't worry about it because that the $100,000 will surely turn into $1,000,000 in 6 months, right? How about that hot stock tip? What about the new neighborhood that is going to boom in the next 3 years? However, more often than not, these speculations are simply major opportunities to lose money.
Herein lies the dilemma, how does Peppa get around this problem where she needs such a huge return? Fortunately for Peppa, she has been a regular reader of this blog and so she is familiar with the concept of leverage with rental properties.
Scenario 2: Rental Property
In the second scenario, Peppa decides that she is going to buy a $100,000 rental property. How can she do this if she only has $10,000? Well, she is going to use her $10,000 as a down payment and she is going to get a mortgage of $90,000 for the balance. Here, assume that the $90,000 mortgage has a 4% interest rate, is amortized for 30 years and has monthly payments of $430.
This particular rental property rents for $1,000/month and has a 50% expenses ratio, so after expenses (taxes, insurance, utilities, repairs, vacancy, etc) Peppa has about $500/month left over to pay the mortgage, and the remaining $70/month she can keep for herself.
After looking at this property, there are a number of ways that she can accumulate the desired equity to build her nest egg, which include: (1) cash flow, (2) appreciation, (3) amortization. We will examine them now.
As stated above, Peppa’s property has a gross rents of $1,000. She accounts 50% of that for expenses, so $500/month will be allotted to taxes, insurance, repairs, utilities, vacancies, and other miscellaneous expenses. The remaining $500 will go to the mortgage and the rest goes into her pocket. To summarize, $1,000 (gross rent) - $500 (expenses) - $430 (mortgage) = $70/month in cash flow. If she simply saves the $70/month, in 10 years she will have $8,400 ($70 x 120 months). While this is good, it is still well short of the desired goal of $75,000
Next, we will examine how appreciation affects the growth of her nest egg. The average historical rate of appreciation for real estate is approximately 4-5%, so let’s assume 4% appreciation for Peppa's rental property. If her home that she bought for $100,000 appreciates at a rate of 4%, it will result in the property having a value of $149,000 in 10 years. This means that Peppa now has accumulated an additional $49,000 in equity. The $49,000 plus the $8,400 of cash flow results in her having $57,400. This is much better, but it is still below the $75,000 goal.
This is an important concept to look at closer, and one that I have written about on prior blogs. While many people look at real estate as being an "average" investment because it only grows at a rate of 4%, which is less than other assets, it is an amazing investment because of the ability to use good, long term leverage to purchase it. Here, Peppa was able to buy a $100,000 asset with only $10,000 cash. Simple math shows that a $100,000 asset that appreciates at 4% will grow much more than a $10,000 asset growing at 4% (or even 12% as shown above). The best part is that Peppa gets to keep all of this extra appreciation for herself. So, it is important that one understand how leverage works and understand the risks and rewards it provides so that one can take advantage of it.
3. Mortgage Amortization
But wait, don’t forget that Peppa has an amortizing loan, which means that it gets paid down over time. This loan started off as a $90,000 loan that amortized in 30 years with an interest rate of 4%. This loan in 10 years will have a balance of approximately $70,000. An important fact is that Peppa did not have to come out of pocket to pay down this loan. Rather, she was able to pay it down with the rents she received from the property. Meaning that Peppa has now found an additional $20,000 in equity with no money out of her pocket, bringing her grand total to $77,400, which is awesome and meets her goal!!!
Finally, Peppa adds back in her initial investment of $10,000, which now brings her nest egg to $87,400.
To summarize, Peppa started with an initial investment of $10,000, and she was able to get an additional:
- $8,400 in cash flow
- $49,000 in appreciation
- $20,000 in loan amortization
- Making a total of $77,400, and then she must include her initial investment of $10,000. Making her grand total $87,400.
So, she turned $10,000 to $87,400 in 10 years!!! This is a pretty amazing job. She was able to increase her initial investment almost 9 times in only 10 years. Pretty unbelievable for a simple investment.
Mind you, this does NOT even include the amazing tax benefits of depreciation that Peppa will receive. (Note: When you are calculating your return on investment, be sure to sit down with your tax professional to see how what your specific tax savings would be and how they can increase your return even more.)
Now, let’s figure Peppa's return on investment of her initial $10,000?
Answer: Enter the following numbers in your HP10bii Financial Calculator. (If you don’t have one, no worries, simply follow along)
N (Number of Months) = 120 (120 months in 10 years)
I/YR (Interest Rate/Year) = ???? (this is what we are solving)
PV (Present Value) = (10,000) (This is Peppa’s initial investment. Notice that it is to be entered as a negative because Peppa loses access to it while it is growing)
PMT (Monthly Payment) = 0 (There are no monthly payments)
FV (Future Value) = $87,400 (This is the final amount of equity plus cash flow she has after 10 years)
Her return on investment in this deal is 21.88%!!!!!
This return in amazing, and to think that a couple of paragraphs ago we were screaming that a 20% return was impossible. The important thing to note is that this amazing return is not terribly speculative. It is not dependent on some market factors that are out of the ordinary happening. Rather, it is a pretty “ho-hum” market appreciation that falls in line with historical trends.
Also, the risk is relatively low. Even if the market does not appreciate like it has throughout history, it is not a big deal. The most important part of the deal is that the rents from the property pay for the the mortgage and expenses and Peppa does not have to come out of pocket to support it. That way, if the property does not appreciate (or drops in value) over the next 30 years, then Peppa simply ends up with a free and clear property that only cost her $10,000. Not bad at all.
Finally, I think that it is important for people to understand that there are awesome investments (like this one) that don't require one to put their capital in high risk situations. I have had tons of people tell me, "Anything over a [2%, 3%, 4%, or fill in your number] return is very risky and should not be done." That statement drives me crazy as it is not true!! However, the idea that investments with low returns are automatically safe and high returns are automatically risky is disseminated all over culture as if it was the law. The truth is that you can have an investment that gives you 1% return that is very risky, and you can have another, like the one above, that gives you a 21% return that is relatively safe. However, the important part is that you educate yourself so that you understand how the investment works (i.e., where is the return coming from), that helps you to see what is truly risky and what is safe.
In closing, the investment above is relatively safe, not terribly speculative, and is available to almost everyone. In other words, this investment is BORING! When you are dealing with your money, boring is good! Get your excitement from some other activity, like roller coasters, but do NOT get your excitement from your investments, as it will not be a fun ride. Continue to increase your financial education and look for those "unexciting" investments that will give you the returns you need without providing extra heartburn.
What do you think about this way to increase your nest egg without speculating? I would love to hear your thoughts. Please write your comments below and I will respond.
Why do you assume 50% expense ratio? I have a mortgage and my expenses are much less than 50%; are you implying that there are more taxes/costs because this is a rental property?
Hi Justin, thanks for the reading and for your comment. I am assuming that you are discussing your personal residence, correct? If I am wrong, let me know.
The 50% applies for rentals as it is 50% of the gross rent collected(no rent is collected for a personal residence). With a rental, when one collects the rent, most people assume that they get to keep everything that is not going towards the mortgage, but that is not the case. They have to pay taxes and insurance (just like a personal residence), utilities for multi families, then they have those months of vacancies where no rent is collected, and they also have those “uh oh” moments when you need a ton of cash to do a major repair. Some examples could be a series of vacancies in multi-family property that require major rehabs, roof replacement, plumbing replacement, major damage to property not covered by insurance, etc. Some years, the expenses are under 50%, but every couple of years, the law of averages comes back and the expenses are way more than 50% of the rents collected (I am currently going through one of those years now).
Granted, if you rent a single family home it could be a little less (40%) as the tenants in single families tend to stay there longer and they cover more of the utilities than a multi-family.
Does this answer your question? Is there anything that is unclear?
Thanks again, Justin, for reading and for your feedback.
Great example of a solid investment. Looking forward to future blogs.
Hey Eric, thanks a lot for taking the time to read and for the kind words. I am glad that you liked it. Look forward to providing you with more helpful content.