“5 is the magic number.
Eventually, [investment properties you acquire will] pay for more of themselves.”
At a dinner with a good colleague of mine we were discussing our ambitions with real estate and our career paths in general. Our academic backgrounds and risk appetites diverged widely. He was a carpenter by trade who also had built dozens of houses from scratch over decades, but extremely risk averse and did not even believe in mortgages after living through the demise of the 1980s. He built homes, but would never get a mortgage for one himself. All his other assets were purchased with cash, and savings was kept entirely in cash. I myself came from an oilfield, road construction, electrical, financial, and mathematical background- with a very hungry risk appetite. I was comfortable with volatile contract and seasonal income and did not believe in (typically perceived) “stable” salary jobs. I was always looking for new investment and business avenues- even with debt, as long as it made me money. Nevertheless- we shared one common ground- an appetite for wealth in real estate, and that day he made a noteworthy comment:
“Eventually, they’ll pay for more of themselves.”
As addressed in my past writing, my overall current objective is a Ferrari by 30 (I am 24 currently). Based on historic trends with allowance for margin of error, this requires a minimum of 3 properties in the low to mid $300 thousand range in the Edmonton area (or other parts of Alberta of similar characteristics).
As my colleague is risk and especially debt averse, he figures the magic number is 5 paid-off, mortgage-less properties of this calibre: each approx. $1,150/month net gross income before upkeep, transaction costs, and taxes:
Rental income: $1,850
Condo fees: $492
Property tax: $214
Income before upkeep, taxes, transaction costs: $1,150
Property value: $350,000 (approximate)
Cashflow ROI: 3.9%
Projected appreciation: 4-5%; assume 4.5%; $15,750
Total profit per year: $29,550
5 of such properties = $147,750 gross income before expenses.
Total cash-on-cash return: 8.4% before expenses.
Following his comment, this makes sense- as even if $10,000/year is budgeted for maintenance and upkeep across the 5 properties, and assigning a pessimistic 1/12 month of the year vacancy rate ($9,250), $128,500 before-tax income is produced by 5 properties. This is a figure the average Albertan is happy with and breaks the 6-figure threshold that is usually socially praised and sought. Obviously each person has a unique spending pattern and hence lifestyle and there is no universal “one size fits all” income. Though in 2012, studies have shown that the positive correlation between income and happiness ends at around $75,000 across Canada on average; $82,800 in today’s dollars factoring in a 2% inflation rate. For strict cashflow, the 5 properties’ yearly pre-tax rental income of $49,750 after upkeep and the above allocated vacancy rate is enough for someone with a moderate lifestyle to live on. Based on this analysis, my colleague’s comment of 5, the magic number, makes sense.
Now to address the “pay for themselves” part. Cashflow is regularly liquid, but appreciation not without transaction costs. Assuming the investor continues to work and lives entirely on such income, there are multiple approaches to make the 5 investment properties self-growing, but strictly using cashflow being the simplest one:
Using the 36.5% marginal tax bracket that the investor is likely in, given common Alberta income ceilings and sufficient income to acquire the properties overtime, this implies an after-tax cashflow income of $31,591.
To acquire the 20% downpayment and $1,000-2,000 transaction costs, it would take 2 years and 3-4 months to get another property of $350,000; shorter amount of time for a less expensive, though lower earning, property.
However, even those with a moderate degree of risk aversion realize even the before-expenses return of 8.4% calculated above is inferior to that of many ETFs, blue chip stocks, and other similar investment avenues- many with much lower transaction costs like legal fees, property taxes, and real estate agent commission, and greater liquidity from ease of buying and selling. There is also no worrying about troublesome tenants causing heavy losses and upkeep of property, though now you have a new worry of incompetent management teams, greater volatility, and common investor psychology and public scrutiny associated with equities.
Given inferior cash on cash returns of this and most non-Vancouver and Toronto real estate, most investors seek the available <=5x leverage (up to 20x on some accounts) to amplify returns that is not available for equity investors. In the 5 property scenario of this article, it also dramatically reduces the amount of time required to acquire them (and is much more realistic outside having a wealthy family or quickly becoming a millionaire), and hence the opportunity cost of forgone income during waiting. In my personal scenario, I’d be nearing retirement age already if I were to depend only on cash-on-cash returns, and very well take 2-3 more decades to be in a Ferrari, versus by age 30.
With 20% down on 5 of these properties of $350,000 each,
2.74% 5-year fixed term interest in 1st year: $37,650
Initial investment required: $350,000 + 5,000 legal fees
$85,850/year pre-tax income, after $5,000 initial legal fees and above listed expenses
However, the mortgage payments would force such an appreciative property portfolio into a negative cashflow position, making it impossible to expand it without the liquidation of a portion of it. The mathematics of such a scenario is rather complex and deserves its own article, that I will write at a later date. So far we have been also assuming generally linear appreciation and expense curves; in the real world, these figures can be more volatile. The mathematics are also dependent on each individual’s tax situation in a particular year, and the time of sale, as many transaction costs are fixed or semi-fixed. That is, the longer one waits to sell, these expenses are amortized over a longer period of time and hence are less “yearly”- though the longer one waits to sell, the more equity is at stake- which may actually reduce ROI, as mathematically, ROI is lower the larger the investment is, for a given return (appreciation and rental income).