Licensed Real Estate Brokers | Property Managers
If you bumped into your realtor and asked him or her to calculate the ‘cap ratio’ or ‘cash on cash’ of a building you were considering buying what do you think they would say? If they look at you like Bambi in the headlights you might want to reconsider your realtor. Investment real estate is a different field than residential real estate. We have been working in this part of real estate since the late 1990s.
The reason real estate investing has never gone away, regardless of the economic conditions, is that people always need a place to live, to work or to run a business. From a $60,000 condo to a shopping mall, there is a place for everyone in real estate investing. Whether you are a rookie looking to get into real estate or a seasoned pro, Uptown Realty has something to offer you. Both Scott & Jeff have been active real estate investors for a couple decades and it is in their blood, like it or not. They also have been running the Management side of the business and the perspective gained from operating well over 100 units of rental housing and commercial units is valuable. We can size a property up pretty quickly, by formula or by observation.
A “Real World” Study
Steve & Susie had competing ideas on how to invest for their future. Susie liked the idea of a well-rounded “Wall Street” portfolio and Steve favored investment real estate. Let’s follow their story:
The year is 1993. The European Union was being created, US Federal Officials stormed the Branch Davidian Cult in Waco, TX and Monica Lewinski was just another student at Lewis & Clark College in Portland.
Steve & Susie had saved up a little over $50,000 and decided to challenge each other’s investment beliefs and see how each fared after 20 years. Steve found a really nice, well-maintained 4-plex at 4100 Pleasant Avenue South in the Kingfield neighborhood of South Minneapolis. Kingfield wasn’t quite as nice as it is today and the purchase was considered risky by Steve’s parents and most of his friends except the bicycle riding malcontents he hung out with on the weekends. Nevertheless, Steve negotiated a price of $133,900 and invested the 20% down payment of $26,780. The building had 4 1-bedroom, 1-bath apartments with nice hardwood floors and plenty of charm. Each apartment rented for $450.00 in 1993.
Susie researched stocks and decided to buy a portfolio of four stocks so she was diversified. She bought McDonalds, Target, Microsoft and CitiGroup. She split her $26,780 in equal quarters and bought 137 shares of McDonalds, 99 shares of Target Corp., 79 shares of Microsoft and 102 shares of CitiGroup. Susie did nothing for the next 20 years except garden, put dividend checks in the bank and drink entirely too much wine. Her investment path would be easy; No maintenance, no phone calls and no lawn mowing.
Steve took stock of his duplex and decided that since the building was in good shape he would maintain it as needed, mow the lawn himself since they lived next door and try his best to keep it rented to nice folks who would pay the rent. As things needed fixing he had them repaired and occasionally he remodeled a kitchen or bathroom as needed to keep quality tenants. He had to replace the driveway because the city sent him a violation notice. Generally, his ownership experience was very typical and while slightly frustrating, he was happy as a landlord.
Times change and it is time, 20 years later, for Steve & Susie to move to a warmer climate. They have saved in their work 401Ks and are eligible for social security so they are going to liquidate their investments and buy a nice home to live in. They think Palm Springs, CA sounds nice. How do you think the two approaches will compare now that it has been 20 years?
Let’s look at Susie’s performance first. Her 4 stocks all did well. If we include stock splits, all dividend payments and the increase in share value we should have a very true representation of the performance of Susie’s stocks. The $6,695 she invested in McDonalds is now worth $63,471. That is a lot of Big Macs! The $6695 she invested in Target has turned in to $85415! Microsoft did well too, now worth $115,934. Citi Group was the big disappointment, now worth basically what she paid, $5493. The saddest part is that Microsoft was sky high in the middle of it’s arc from $6695 to $5493, but she was busy in the garden and missed the peak. After telling her broker to sell it all she received a check for $270,314.
The duplex had gradually increasing rents. The 1993 rents of $475 are now $725. There were some years of rampant rent increases and some flat years. The mortgage was flat because Steve never refinanced. Expenses were not flat though. Taxes nearly doubled from $2997 to $5775. Insurance also skyrocketed from $650 to $2200 per year. We considered the following expense categories: Tax, Insurance, Maintenance, Utilities & Rental Licensing. We also accommodated for Vacancy and Improvements, like new kitchens and the driveway. We tried to be very realistic about all of our income & expenses. We also gave Steve credit for Depreciation, for the accountants in the group.
Steve put the fourplex on the market and after negotiation reached a sale price of $350,000. After paying all of his selling expenses like commission and paying off the remainder of his mortgage he received a check for $263,382. BUT, since he was a smart landlord he has made a little bit each month and put it into a savings account. His accumulated earnings, after taxes, for the past 20 years totals $167,743. Steve’s overall income is $431,125. Steve is way ahead of Susie convincingly.
However, the story isn’t over. Uncle Sam has a role here, as he always does. Susie gets stung with a capital gains tax, we are calling it 21% (15% federal and 6% state) which takes her net gain down to $213,548. Ouch. Steve on the other hand, has a really sharp accountant who taught him about IRS Sec 1031 that allows him to sell the building and invest in another realtor property for a higher amount and “defer” 100% of his capital gains. Brilliant! So, you say, what do they want with another rental property? Well, follow me here….They are going to pool their assets, a total of $644,673 and buy a home in sunny Palm Springs. They pay cash and their monthly expenses will amount to taxes, insurance and upkeep. They will lease it for one year and then decide to convert it to their personal residence, something the IRS has no problem with. Once they live in the house for two years those capital gains disappear (there is some fine print here but it is no distortion to say that the tax obligation goes away).
In the final analysis Steve’s real estate investment, well-run and carefully managed, pulled in over double 4 well chosen stocks, 3 of which performed beautifully. Real estate requires attention, the stock market does not. However, when you consider the tax advantages and appreciate rental real estate is hard to beat. Steve & Susie own a home that cost nearly $650,000 and have no mortgage. Life is good.