Focus On Investment Opportunities

This week I want to change things up just a little bit and talk about the investment opportunities in our current market. I try not to get too "salesman-like" on this blog - I really want this to be more of an informational resource than anything. But look, there's a reason why 18.1% of the transactions in this market were cash deals last year. The word is out, and this market is starting to be seen as a prime investment opportunity by investors both in and out of this area. As you may recall if you've been reading this blog, Diane and I are big enough believers in the value in this market that we jumped on an investment last year ourselves.

Before I start throwing some numbers and scenarios at you, let me make a distinction that I personally make when I'm talking about these types of things. When I think about real estate as an investment, I tend to think of it as a long term "buy and hold" proposition. I personally think that this is the best way to approach it over the long haul. In a rapidly appreciating market like we had a few years ago, we see a lot of people looking for short term gains. I don't begrudge them that, but it's a risky move, and more than a few people doing that lost a lot of money when the market turned on them. There's an old Wall Street maxim that I've heard that rings true here: "Bulls make money, bears make money. Pigs get slaughtered." Now don't take that the wrong way - I'm not calling anyone a pig here. I'm just pointing out that thinking short term with this level of investment is risky, and it can bite you in the end.


Oh, and another disclaimer here - I'm not a tax expert. I know generally that there are some tax benefits from owning real estate as an investment, but I leave the details to the pros. So I'm not going to factor in the tax ramifications of a real estate investment into this post. If you have questions about taxes, go see your tax accountant. If you don't have one and you want to go this route, get one. We personally use Walker, Wilson and Hughen, and highly recommend them to our clients.


OK, let's look at a few scenarios:


Cash Is King


Let's say that you have some cash that you want to put into a real estate investment, but for one reason or another, you don't want to leverage it with a loan. In our case, this is the route we went out of necessity. Getting a mortgage as a Realtor these days is kind of dicey, and most reasonable lenders would pass out from laughter if we went to them with our past few years of tax returns and asked for a loan. So let's do this at a couple of different price points and see what it looks like.


Your typical 1960 tract home priced at $150,000 in town is a good place to start. Most of these are pretty rough, so you probably need to plug some money into them. Let's say that you're like me and you have limited time and handyman skills. You need a contractor to do some work, and it needs paint & carpet, maybe it needs some termite repairs, etc. So let's put another $25,000 on top of that for the sake of this discussion. And you'll have a minor amount of closing costs, probably around $1500. So you're in with a total acquisition price of $176,500.


Probably a ballpark average on rent for this house is somewhere in the $1250 range. So let's figure on that, and say that you don't want to manage the property yourself, so you hire a property management company. You'll probably write off about 5% of the income, plus a percentage of the first month's rent. You'll need to pay property taxes on it as well, about $1875 a year for the first year with no more than a 2% increase annually. Hazard insurance is probably something on the order of $500 a year. Figure on about a 10% vacancy to be on the safe side, but hopefully you'll have better luck than that. And you'll have some maintenance to do on occasion. That's hard to predict, but let's say it's around $2000 a year. So using some relatively pessimistic assumptions here, we're looking at the property bringing in $8450 a year after expenses. That's about a 4.8% annual return on your investment before taxes. Not setting the world on fire, but not too bad. And while it's not as liquid as most investments, it's going to see some appreciation over the long haul as well in addition to the income.


Let's look at another cash scenario. Let's say that you have $80,000 to put into this investment. Now your options are a little more limited, and you might have to be a little bit more patient. Now we're probably looking at a condo. Let's say that you find one for $70,000, and need to put some paint and carpet into it. Between that and the closing costs, you wind up with a total investment right at $80K. Now let's look at the income side of it. You're probably looking at a 2 bedroom unit, maybe a Lompoc Village or Cypress Woods. We'll assume about $850 in rent on that. Property taxes should be about $875. The same property management and vacancy rates are probably good numbers to work with. But we have to factor in HOA fees, and those have been going up of late. Let's work with $275. Adding it all up and taking out the expenses brings in about $4500 annually before taxes. That's about a 5.5% return.


Use Other People's Money


Here's where it gets good. I talked to one of our preferred local lenders, Pat Leachman at Main Stream Financial this afternoon to check in on his non-owner occupied rates. As of today, he's quoting us a 5.25% rate on a 30-year fixed mortgage with 20% down, and 5.5% with 20% down for well qualified borrowers.


Great Googly Moogly! Those rates are just unbelievable.

OK, let's run that $150K scenario through this with a loan factored in now. If you put 25% down, that's $37,500. Your closing costs go up when you take out a loan, so I ran these numbers through a program that we use to estimate these things, and it looks like about $9000 in closing costs. Add in the $25K in repairs that we figured above, and we're looking at about $71,500 to get in. The monthly payment factoring in property taxes and insurance comes to about $825. Using the same income/expenses assumptions as above, and taking out the taxes & insurance (because it's in that monthly payment), you're looking at about $2350 annual positive cash flow. We're down to a 3.3% return on that $71,500 before we talk about taxes, but hang on there - talk to your tax pro about this. The ones that I've talked to have much better things to say about leveraged real estate investments than they do cash investments from a tax standpoint. And the growth over the long term on the property value looks a lot better when you look at it in terms of the cash you laid out. Say that $150K become $200K in a couple of years. Now what's the return on your $71,500? What about 10-15 years from now?

If you go the 20% route, the numbers change a little bit. I've probably done enough math here, and if you're still reading this, thank you. In a nutshell, that investment works out to a slightly smaller positive cash flow, but a little better annual return on the initial investment. Do I even need to go into the condo scenarios with loans? Probably not, and with a lot of our low price condos being a bit problematic for loans, it's probably an academic exercise at this point.

So do you see why we have so many investors in our market today? I've tried to use some pretty conservative, bordering on pessimistic, numbers on those scenarios and it still pencils out any which way you look at it. I'm not a financial genius, but I'm telling you - if you believe in the long term value of real estate, we have the perfect storm of prices in our market and interest rates to make right now a historically prime opportunity to make this investment.