For this last case study, I’ll use a real life investment that I know of.
Right at the end of housing crash, you inherited some significant cash from a grandmother who passed away after a long illness. Living overseas in a low cost area, you decided it’s best to invest the inheritance instead of spending it. The question is, what should you invest in?
You have a buddy who is a real estate agent who knows your hometown’s housing market very well. Knowing you have large sum of cash to invest, he suggested looking into a condo building that were newly built right when the housing market crashed. He knew the property company was desperate to sell and can get you a huge discount. He also convinced you that the housing price had bottomed in the area and would only increase from this point. Plus a large employer just moved into the office park next door and a lot of employees relocated with it are looking to rent in the area.
With an expert on your side, you pulled the trigger and bought a unit. Since you’ve been overseas for a long-term and doesn’t have too much ties in the US, you thought qualifying for a mortgage would be a hassle. So you invested the entire sum of cash in the unit recommended by your buddy.
After 5 years, the housing market has indeed rebounded and you found one tenant who stayed there for the entire time. You are wondering about the return you’ve made and whether you should sell it. Here’s what the worksheet tells you.
Property and Mortgage
- You bought the condo at $750,000 with cash.
- You found that the same units in the building are now selling at 1.1 million.
- You’ve owned the property for 5 years.
Rental Income and Expenses
- You’ve rented your property out to the same guy for 5 years at $3,500 a month.
Annual Ownership Cost / Rental Expense / Transaction Cost of Purchase + Sale
- See the screen shot below for my assumptions. Note that they may not be representative of what you will pay, since they are dependent on the property, locality, state, and various other factors. Make sure to do your own research on how much it would likely cost you.
(Consult your tax adviser if you are not familiar with tax liability and benefits relating to owning a property or receiving rental income.)
- After depreciation, your rental profit is roughly zero. Therefore there is no tax benefit for you.
- You assume the cost of owning and selling the house will increase by inflation of 2%.
Given all the facts above, if you sell the property today, your real investment return is 2.79% year over year for the last 5 years.
This sounds like a small number, especially when you earned $350,000 from the property’s appreciation alone. However, what we normally don’t think about under this type of situation is the transaction cost involved in realizing the value, including all the level of taxes you need to pay along the way.
If you had all the money a well-diversified US stock index fund, such as VTI for example, you would have made 11.66% real return (13.29% nominal return adjusted at 2% inflation) annually in the past five years. Of course, hindsight is always 20/20. It is just as likely that you would have not made at least 2.79% real annual return in a different market condition.
On the other hand, you also couldn’t be sure whether you can find tenants for the entire time. Let’s say you only had tenants for about half of the time, the return drops to 2.41%. The decrease may not be as big as you think. This is because the main source of profit of this particular investment comes from the quick appreciation of value. The rental income in comparison does not give you as much value. This may or may not be true for different investment opportunities.
For such a short timeframe, investing in a good real estate investment opportunity (if you have the insight) can be as or more profitable than in the stock market. But in this scenario, when you don’t have any short-term need for the funds, it is likely more prudent to diversify your investment in the stock market than to bet on one single property. Or better even, use leverage to purchase the property that you are reasonably sure will grow quickly in the short-term, and invest the rest in diversified assets.
Using the same example, assuming you use a fixed 30 year mortgage at 4% APR and only put 20% down, you may increase your annual return to 4.30%. That is over 50% higher than your original return. Nevertheless, it also requires you to have some operating cash on hand for this rental business, since your annual rental income does not cover annual costs, now including the mortgage.
This concludes the case studies that demonstrate the different ways you can use the worksheet. You have until 9am EST, December 24, 2015 to download the latest worksheet. Don’t wait and sign up now!
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