The Control Your Cash Open-Book Quiz, Part II

June 12, 2013
Fun with homonyms

Fun with homonyms

 

Today, the 2nd installment in the Control Your Cash Open-Book Quiz. Yes, it’s several weeks late. That’s called sheer procrastination creating anticipation. Anyhow, the Open-Book Quiz works like so: we give you a scenario and a wad of theoretical cash, and you decide what to do with both. See the previous post in the series if this makes no sense. In fact, it almost certainly won’t.

 

You’ve found a house being sold short, and listed at $100,000. A tenant is already renting it, and is on a lease for the next year at $1000/month.  Similar nearby houses sell for $100,000-$125,000. With 20% down, you can get a 3½% fixed mortgage.

Is this a good deal, or not?

Before you sign a contract, or commit the equally meaningful step of walking away from signing a contract, make sure you know exactly what you’re getting into. One way to do that is to always start with an investment policy. You can’t decide what to invest in until you know what outcome you’re looking for, and how much risk and volatility you’re willing to tolerate to get it.

Here we have a cheap house and cheap money, indicative of the historical double nadir we’re experiencing in the prices of both real estate and its financing. Even though today’s post is only a fictional exercise, the truth remains: Never has there been a better time to buy a house, especially as an investment. We’ve been saying this for years, but market forces (and governmental perversion of them) haven’t yet changed enough for us to recalibrate our opinion.

The 3rd selling point here is the immediate tenant. One who’s already on a lease is a perfect illustration of how vital cash flow can be to an investment that looks good on paper but might not work in practice. No matter how attractive an investment might be, you can’t build wealth entirely on speculation. You need monthly checks. Preferably sooner than later. That empty plot of land on the edge of a burgeoning town might octuple in value over the next 18 months. Or it might just sit there without anyone ever making an offer. Ceteris paribus, buy the property that promises you income while you’re waiting for effortless riches down the road.

To determine the value of this investment in comparison to others into which you might commit a comparable amount of money, you need to get to a common rate of return.  Apples vs. apples and all that. That means it’s time to do a little math. In these examples, we’re going to calculate the value of the property based on its cash flow only.

Here are the terms and formulas you need to know:

Potential Rental Income. The shekels generated by the property in a theoretical, fully rented world. A world where you never have a vacant day, and in which every outgoing tenant is replaced by a fresh tenant later that evening. This world can only be approximated, never reached.

Vacancy Rate. The number of empty, unrented units in the property, divided by the total number of units. This only applies to properties with multiple units, of course. A 10-unit apartment complex with 8 rented units has a 20% vacancy rate. A 1-unit house has a vacancy rate of either 0 or 100%.

Gross Rental Income. Potential rental income x (1 – the vacancy rate.)  Intuitively, this should make sense. Call (1 – the vacancy rate) the occupancy rate if you have trouble with abstractions.

Operating Expenses. All the costs of running the property excluding the loan payment.

Net Operating Income. Gross Rental Income – Operating Expenses.

(It’s obvious that those are minus signs and not em dashes, right? Oh God it isn’t, is it? Start again from the top.)

Cash Flow (before taxes and depreciation.) Net Operating Income – loan payments.

That’s the big one, the one that marks the difference between legitimate landlords and people who are just treading water until they’re forced to sell to someone who knows what she’s doing.

Now that you know how much cash will flow from your potential investment, you need to find out how it compares to other potential investments. By using these handy formulae:

Capitalization rate. Net Operating Income/(Purchase price + closing costs)

Cash-on-Cash return. Cash Flow/(Down payment + closing costs)

Run the numbers for those last two right now. We’ll wait.

Most investors focus on capitalization rate to the exclusion of everything else. On some level, capitalization rate (or if you want to sound knowledgeable, “cap rate”) is the closest analog to the rates of return you can expect with other investments. Mutual funds, etc.

Cash-on-cash return, which should be several times higher than cap rate if you did this correctly and checked your work, is the investor’s grand secret weapon. And testament to the wisdom of getting rich off OPM. Wait, that means it’s time for one last formula:

Other People’s Money. Your investment – your personal funds invested.

You can’t do this without leverage. Which is to say, without borrowing money from a lending institution and focusing it on an opportunity that promises you a greater capitalization rate than the interest you’re paying the bank. Capitalization rate measures cash flow of the property relative to investment. Cash-on-cash return changes based on how the buyer (that’s you) finances. The cheaper the financing, the higher the return.

In our above example, the cap rate is 7.77%. The cash-on-cash return is 15.10%.

Where else can you invest $26,000 and get that kind of return?

Wait. We’re not done yet. There are the tax benefits. You’ll be able to deduct the expenses of the property, plus depreciation (about $2,500 for this property) against the income you earn.  Your tenant will be paying your mortgage payment, which means every month you’ll own a little bit more equity. Finally, the property might just appreciate it value. There’s a downside, but it’s outnumbered.

 

Note: The information we used appears on the attached spreadsheet. Should you be inclined to download it, it’s called an Annual Operating Property Datasheet. In the real world you’d get this information directly from the seller, or from your realtor if she’s any good. Failing that, go to your county assessor or tax collector website.

Filed Under: Investments, Math, Real Estate Tagged With: ,

The Control Your Cash Open-Book Quiz, Part I

May 9, 2013
Today's kids have terrible posture

Today’s kids have atrocious posture

Presenting the Control Your Cash Open-Book Quiz, complete with answers. For each of our next 3 posts (excluding Monday’s upcoming Carnival of Wealth), we’re going to put you in a fictional but plausible financial scenario. If you can figure out what steps you should take, then congratulations. You’ve got this stuff figured out and should be busy making deals instead of reading our site. This will make more sense once you read the 1st example:

 

Your friend just came back from Hawai’i, and you can tell it made an impression on her because she’s taken to spelling “Hawai’i” with the ‘okina. She and her husband bought a timeshare condo and think you should buy the adjacent one. That way you can take vacations together (!), which some people are into for some reason. If you ever get sick of Hawai’i, you can always exchange your timeshare week for one in Mexico, the Caribbean or Miami.*

 

The annual maintenance fees on the condo are $804, and the cheapest financing you can find is 11½%.  You’re going to put half down, and after 5 years all your vacations will be free.

What questions should you ask?
Do you have enough information?
If no, what else do you need and where would you get it?

 

When we’ve given this scenario to people in real life, the sharper ones usually stop and say, “Wait a second. 11½%?”

 

We were being conservative. That rate is generous by timeshare lender standards. Here’s a company (DON’T CLICK THAT LINK, WHATEVER YOU DO) that charges 12.9% for the same loan. Why is timeshare financing so exorbitant, when the average residential loan is going for less than 3½% right now?

 

Profit maximization, that’s why. That, and one dumb customer base. Payday loan places charge 350% annual interest, rather than 5% or 10%, because their less-than-savvy customers want cash and they want it right now. Paying attention to rates? That’s for chumps. In the same vein, liquor stores not only kill alcoholics’ brain cells, the drunks pay them for the privilege (cf. cigarettes.) Someone on a modest income who has overconfident dreams of being a regular visitor to the Na Pali Coast isn’t going to be swayed by usurious interest rates. And no one ever said that both parties in a transaction have to be acting rationally.

 

The maintenance fee we gave was modest, too. But timeshare owners renters justify what they pay, because that’s what Monkey Brain (® Jason Hull 2013) inevitably does. A prospective timeshare renter sees $804 as a mere $15 a week. That little to keep the place painted and sprayed for bugs? Deal of the century!

 

Again, look at every deal from the other party’s perspective. (Which should have been the book’s title, except it’s unwieldy.) $804 in maintenance costs. Multiplied by 52 owners. The timeshare company is getting $41,808 a year per unit. No condo unit requires anywhere near that much maintenance, not even if DeAndre Hopkins and Mark Harrison each own a week. The $41,808 isn’t pure profit, but it’s a juicy markup.

 

The timeshare resale market is vibrant, and populated by buyers considerably smarter than the timeshares’ original buyers. If you made the error of buying a timeshare in the first place, you can expect to recoup no more than 20% of its price when you sell.

 

Why? Because the maintenance fees never go away. Nor do they ever decrease. Worse yet, many properties aren’t even owned by the timeshare companies that sold your week to you in the first place. Instead the properties are on long-term leases, which means that your timeshare will only be valid for the length of the lease. You’re not going to believe this, but that’s rarely the first line in the sale agreement.

 

There’s always someone who can justify buying a timeshare even though it’s a horrible investment. Here are a couple of the most common justifications:

  • It’ll be invaluable family time. Spending vacations together is more important than money could possibly be.
  • It’s not a “timeshare”, so much as it’s vacation ownership.

 

Yes, these objections are being articulated by a fictional rebutter of our own creation, but they’re still used all the time.

 

Few things have value that transcends money, e.g. health, eros, eternal salvation. A temporary living space in a desirable location doesn’t count, especially since it’s not a necessity. Nothing’s stopping you from buying plane tickets and renting a one-bedroom suite like normal people do. Which brings us to our second justification.

 

“Vacation ownership.” Think about that one for a minute. That the concept has to be shrouded in a piece of business jargon should tell you something about how valid it is. A vacation is temporary and evanescent, not unlike a round of golf or, for an even more commonplace example, lunch. The idea of somehow possessing it, whether in perpetuity or for future sale, is absurd. You purchase airfare and a room, you go on vacation, you come home, you pay your American Express bill in its entirety at the end of the month. The end. What is so hard about this, and why would you prefer a different method in which the payments never end?

 

On top of everything else, timeshares are the one “real estate” “investment” with zero tax benefits. You might as well just put the money earmarked for maintenance fees into a money market fund, and use that for a vacation each year.

 

Timeshares are among the starkest counterexamples we’ve found to the buy assets, sell liabilities mantra. On an individual level, there are few more efficient ways to impoverish oneself.

*Yes, we’re aware that Mexico and the Caribbean aren’t mutually exclusive. You go to the front of the class, Geography Dork.

Filed Under: Investments, Math, Real Estate Tagged With: ,

Don’t Drown In Sunk Costs

January 23, 2013
This activity makes no sense. Unless the guy in the Oxfords is placing the penny down to see what cheap soul picks it up.

This activity makes no sense. Unless the guy in the Oxfords is placing the penny down to see which cheap soul picks it up.

 

It’s amazing how many people will congratulate themselves for such money-saving machinations as calling the cable or phone company to get their monthly bills reduced by a buck or two, yet won’t expend similar effort to save themselves tens of thousands. Here’s an example:

You borrowed $200,000 to finance your house 5 years ago at 6.57%, after putting 20% down. Should you refinance?

Yes.

30-year rates are now 3.47%, 15-year rates 2.84%.

Your balance should now be $187,124.51. (That’s right. After 5 years, 94% of your balance remains. Pretty impressive, huh? Sorry, but this is how interest works. It’s why you should be a lender.)

You can pay 6.57% on the $187,124.51 for the next 25 years, continuing to make monthly $1,273.36 payments. But if you refinanced, you’d pay:

$1,277.90 a month for the next 15 years. For an extra 4½ bucks a month, you could burn your mortgage a decade quicker. Would that be worth it?

Depends on how much refinancing costs are.

We’re assuming that your credit is good. If your credit isn’t good, refer to page 33 in Control Your Cash: Making Money Make Sense and treat consumer debt like the hantavirus that it is. If you’re carrying balances on your credit cards, balances that you pay the minimum on and don’t expect to pay off for years, dig deeper. You’re an individual, not a government. You can’t do this indefinitely, and better you endure brief sharp pain than enduring dull pain. In fact, you shouldn’t even be wasting your time reading blog posts. Go out and get a second job, and stop spending money beyond the essentials. Once you’ve done that, and you’ve eliminated your consumer debt, come back.

(Good. With those folks out of the way we can get down to business.)

So what are the costs of refinancing, anyway?

The largest expense is the loan origination fee, which will almost always be 1% of the new loan. $1,871.24.

Appraisal fee. The lender doesn’t want to refinance your lean-to at Windsor Castle prices. Call it another $500.

Inspection fee. Even if it is a lean-to, it needs to be habitable. Pencil in another $225 or so. You’ll also need a pest inspection. Maybe $50 if you live somewhere like North Dakota, $75 if you’re in Florida, The Palmetto Bug State. You might also need a flood certification, $75, to prove you live (or don’t) in a flood zone.

There are also credit reporting fees at around $150. Plus recording – formalizing and registering the transaction documents with your county assessor’s office or whomever. Call that $35.

Depending on which state you live in, a reprobate lawyer might need to get his piece of the action. $750 for attorney review, because reading a series of boilerplate documents requires someone with an advanced degree and a goodly amount of self-loathing.

There may be other fees too. When you ask your lender to quote a rate, make sure they include a breakdown of all closing costs, including the costs charged by any closing agent. Compare the interest rates of any “no-cost” refinance to one with costs. Lenders will usually increase the loan’s interest rate by 25-50 basis points to cover the costs not collected up front.

Tally it up, and that’s $3,681 for the privilege of paying another $230,022 over the next 15 years, instead of paying $382,008 over the next 25 years. An investment that pays 41-fold, maybe minus a few multiples for the accelerated payoff. Hopefully you don’t need to be convinced further that that’s a fantastic deal.

Last week we wrote Part I of how we manage to remain liquid, comfortable, and reasonably affluent in Year 5, maybe 6 of The Recession That Politicians Wouldn’t Let Wither. Some people thanked us for and were inspired by the first-person perspective. Others decried us as out-of-touch and haughty with no understanding of the world beneath us, Mitt Romneys in a sea of 47-percenters.

The secret to building wealth is that you don’t need to shoot superlatively high. Sure, Sergey Brin and Larry Page beat you to the idea of creating a search engine that could metastasize into an entire online ecosystem, where hundreds of millions of people willingly share personal information that can be monetized. Brin and Page are billionaires several times over, while you aren’t and never will be unless Obamanian/Bernankite hyperinflation becomes reality. Does that mean you should look for the next cosmically resonant opportunity instead, which simple probability dictates that you’ll probably fail at?

NO. There are other choices beyond aiming that high, and aiming small. Taking a few hours to save $152,000 over the period of a home loan is what people with a wealthy mindset do. The ones who don’t, don’t because it:

  • Is more involved than just picking up the phone and calling Verizon Wireless’s billing department.
  • Involves using the services of other people, some of them experts who charge fairly for those services.
  • Requires a little math.
  • Might result in nothing. (If there were less of a difference between current mortgage rates and what you’d borrowed at originally, for instance.)

Cursing the darkness might make you feel briefly better, but that’s not what we do here at Control Your Cash. Instead, we prefer to take aggressive, intensive steps to significantly increasing revenue (or significantly reducing expenses.) If you’re going to chase pennies, chase them tens of thousands at a time.

Filed Under: Estate Planning, Finance, Real Estate Tagged With: , , ,
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