What is better: cash-flow ... or higher ROI ?

[Thomas Beyer]

Real estate is like a three course meal (TM). It has three profit centers: cash-flow (or the appetizer), mortgage paydown (the main course) and equity appreciation through asset improvements and inflationary rental upside (the dessert).

One key question is: how much cash to put down and how much leverage to apply via a mortgage. The more cash down, the higher the cash-flow.

Is this better though ?

REITs typically use 50% or less leverage and can be good investments or should one be higher levered with more equity upside, but little or no cash-flow ?


Let's look at three scenarios. What is a better investment of a hypothetical $1M (say by the time you intend to retire or from an inheritance) ?:

1) a $4M building with $1M invested with a $3M mortgage, or
2) a similar but smaller $2M asset with the same $1M invested, but only 50% levered, or
3) a mortgage free asset at $1M ?

Assumptions:

a) 6% asset yield, also referred to as a CAP rate,
b) 4% interest on the mortgage with 25 years amortization,
c) 0.5% annual overhead costs (really: a reduction in the CAP rate to 5.5%)
d) 1% annual investment into the asset for minor upgrades/repairs to yield an asset value growth of 2% over and above inflation, and
e) inflationary rental upside of 2%.


Scenario 1:

$1M invested, $4M asset, 6% CAP (yield), 75% LTV (loan-to-value) mortgage at $3M at 4%

$240,000 NOI (net operating income) minus

$180,000 mortgage payment (of which $60,000 is principal and $120,000 interest)

$60,000 `cash-flow` in theory .. Some of which will be asset management fees, annual accounting, tax filing costs, overhead (say $20,000) and rest upgrades (say $40,000) .. Thus NO CASH FLOW

20% value growth in 5 year to $4.8M due to inflation and upgrades/rental upside (4%/year on average)

Equity in 5 years: $800,000 gain plus $300,000 mortgage paydown = $1.1M = 110% ROI (return on investment) in 5 years ..

But no cash-flow !!


Scenario 2:

$1M invested, $2M asset, 6% CAP (yield), 50% LTV mortgage for $1M at 4%

$120,000 NOI minus

$60,000 mortgage payment (of which $20,000 is principal and $40,000 interest)

$60,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead and rest upgrades .. Say $30,000 - same ratio as scenario 1 .. So $30,000 cash flow (3% on the $1M invested)

20% value growth in 5 year to $2.4M - same as scenario 1

Equity in 5 years: $400,000 gain plus $100,000 mortgage paydown plus $150,000 in cash flow = $1.65M = 65% ROI in 5 years with some very modest 3% cash-flow !!


Scenario 3:

$1M invested, $1M asset, 6% CAP (yield), no mortgage

$60,000 NOI

$60,000 `cash-flow` in theory .. Let`s assume some of which will be asset management fees, annual accounting, tax filing costs, overhead and rest upgrades .. Say $15,000 .. So $45,000 cash flow (4.5% on the $1M invested)

20% value growth in 5 year to $1.2M

Equity in 5 years: $200,000 gain plus $225,000 in cash flow = $1.425M = 42.5% ROI in 5 years with some modest 4.5% cash-flow !!


What is better: Scenario 1 ..

Or Scenario 2 ..

Or Scenario 3 ??

 

[Sherilynn]

I'd choose Option 1 and invest the remaining $1m elsewhere for cashflow. (Double down, baby!)

 

[Thomas Beyer]

[quote user=Sherilynn]I'd choose Option 1 and invest the remaining $1m elsewhere for cashflow. [/quote]

Why ?

 

[Sherilynn]

If I had $2m to invest, why not invest in two different buildings instead of putting it all in one building? Option one provides a great return but no cashflow. So I'd buy a second building with my second million, and aim for more cashflow in that one. Then I'd get even more return on my $2m total investment, potentially with some cashflow to boot.



If I couldn't find a building that cashflowed, I'd buy another just like option 1. Then I'd have a $2m increase over 2 buildings instead of only a $1m increase. I could live with that.

 

[moparcanuck]

While I am normally a fan of getting some cash flow, I have to agree with Sherilynn on this one. Assuming one can rely on the numbers as presented, I would go for scenario 1. Why? Because in order to consider it a true apples to apples situation, you have to assume that you have the same cash to start with. If I HAVE the $2 million to use in scenario 2, I would instead buy 2 buildings in scenario 1, making my return $2.6 million instead of the $1.5 million in scenario 2.

 

[housingrental]

It depends



With two million down, the extra million, according to your above numbers, is providing (with no additional risk assuming you have personal guarantee on mortgage in both scenario's) a 4% return



There is a lot of people who would be happy to have this currently



There are others who would prefer to keep cash available for a future opportunity with the hopes of a higher expected return with higher risk

 

[housingrental]

The reason not to is additional risk. This is from:



1) Reduces margin of safety on operations



2) Increases risk of cash call on mortgage renewal



2) can be especially fun if the market value has decreased, and you cannot come up with funds at any reasonable rate to pay off the now due mortgage



There are often higher initial fees to pay with a higher mortgage amount (scenario $1M)



There are many REIN members who expanded in Alberta four years ago that went with scenario $1M that if you ask them will tell you they wish they went with scenario $2M. There might be many more from other provinces in a few years that will be saying the same.







[quote user=Sherilynn]If I had $2m to invest, why not invest in two different buildings instead of putting it all in one building? Option one provides a great return but no cashflow. So I'd buy a second building with my second million, and aim for more cashflow in that one. Then I'd get even more return on my $2m total investment, potentially with some cashflow to boot.



If I couldn't find a building that cashflowed, I'd buy another just like option 1. Then I'd have a $2m increase over 2 buildings instead of only a $1m increase. I could live with that.

 

[Sherilynn]

My answer is based on the assumption that this isn't the only $2m I have. If I had $2m available to put down on a building or two, I would surely have a healthy reserve fund to mitigate the risk.



And as I mentioned, I would certainly be aiming for building #2 to have cashflow. I happen to be pretty good at buying for cashflow (as well as growth) and have managed quite well through the last 7 years, so I think I could make it work.



IMHO, the real key is planning and preparation: hope for the best and plan for the worst.

 

[Sherilynn]

Yes, cashflow is King. However you would be cutting your potential profits almost in half.



Besides, mortgage paydown is Queen and in scenario 1 the mortgage is being paid at an accelerated rate.

 

[Thomas Beyer]

Even Warren Buffet applies some degree of leverage to boost ROIs: http://business.financialpost.com/2012/12/19/leverage-like-warren-buffett-to-power-up-your-portfolio/

 

[Darr]

Of the many sayings about investing, a few come to mind:

`Leverage is a double edge sword`: it makes the good times roll and the bad hands fold.


`Garbage In = Garbage Out`: Forecasting is only as good as the assumptions used.


`Cash is King`: presented without comments.


As `Real` bond yields sink deeper in negative territory, cap rates remain under compression pressure. Consequently, a 3% cap rate assumption (reflecting a trophy asset with no differed maintenance) would yield negative cash flows in a leveraged environment. Moreover, when cap rates are lower than mortgage rates, each dollar of leverage reduces the cash on cash return.


Because of abnormal and unprecedented low yields, leverage investing is extremely dangerous right now.









All this to say that: `stress testing` would produce considerably different results.







About the Financial Post article: Colin Cieszynski, at CMC Markets is `talking his book`.


He has a "leveraged" agenda as they are selling `Spread Betting` and `Contracts for Differences` both highly leveraged instruments.

 

[therenoguy]

Fun game.



Thank you for sharing this with us, Thomas. I've heard you speak about your philosophy of Learn, Earn and Return, and you are certainly returning more than anyone could ever ask by challenging and educating us like this.



My reading of the original post by Thomas says you have $1M to invest. How did we get to talking about having $2M?



Personally, I'm all over the cash flow option. I'm currently in a high asset, low cash flow situation(which I'm slowly changing), and let me tell you it truly sucks. Don't believe me? Tell your kids they can't eat for 5 years, or phone your utility company and inform them you'd like to use their electricity for 5 years, and then pay them at the end. CLICK!(for those of you under 40, that's the sound a real phone makes when you slam it down.)



Cash flow is fantastic. RISK FREE cash flow is even better. And to enjoy (essentially) risk free cash flow for the whole term, and then have a nice healthy capital gain at the end? Why that's just like getting breakfast, lunch, and dinner, as Thomas so aptly puts it, and actually being able to eat it all along the way instead of starving yourself for years.



Oh, and for your next investment, when you go to the bank and utter the words, "...which I own free and clear of any mortgages or debts..." they typically jump you like a teenager on a prom queen.



My two bits...worth exactly that.

Keith.

 

[Rickson9]

[quote user=ThomasBeyer]Even Warren Buffet applies some degree of leverage to boost ROIs: http://business.financialpost.com/2012/12/19/leverage-like-warren-buffett-to-power-up-your-portfolio/




Just to clear up any misconception from people new to the investing game.



Buffett doesn't use leverage like the average person. He doesn't walk into a financial institution, borrow money, and invest to maximize his returns. Unfortunately many people associate "leverage" with "borrowing from a lender". This is not the case here.



In Buffett's case, a huge amount of cash flow is generated by Berkshire's insurance and reinsurance businesses. An insurance company takes premiums from customers up front and pays out claims later down the road. If the premium is priced correctly, there is a large profit that is realized over time. Berkshire uses the premiums (now) to invest, earning a return before claims are paid (later).



In effect Berkshire borrows/leverages from a large number of policyholders.



Thanks to correct underwriting, Berkshire enjoys borrowing costs that have averaged 2.2%. This is more than 300 basis points below the average short-term borrowing costs of the U.S. government.



Another huge advantage that Berkshire has is the stability of this kind of leverage. When one relies on leverage from a bank to enhance returns, the result can be catastrophic if the lender loses confidence. The rug can literally be pulled from under one's feet. This doesn't happen with insurance funding. The results of Berkshire's investments are not correlated with policy premiums written.



This was on display in the late 90s when Berkshire's investments were less than spectacular. There was absolutely no impact on funding from insurance operations.



In closing, Berkshire's "leverage" is not what a reader may think it is. This "leverage" is massively cheaper than anything anybody reading this can get AND it does not dry up under any economic circumstance.



It's a shame that the FP article doesn't even mention the word "insurance" or "reinsurance" when it talks about Buffett's/Berkshire's leverage. This gives readers a dangerous misconception.



To think that Berkshire 'leverages' in the conventional sense would be a big mistake to use as any kind of personal justification for increased borrowing.



PS: My choice would be full equity position with no leverage, with cash flow and capital appreciation. Which is what I'm getting in Phoenix, AZ. By waiting for distressed opportunities, you apparently can "have it all".



Having said that, I can see myself being persuaded to leverage my real estate portfolio in the future to (probably) a maximum of 50%. With prices rising faster than rents in my properties, in the next 5-10 years I will be faced with a significant equity position due to appreciation, which will then be earning mediocre rents.



My best property cost $35k (2 years ago) and was rented at $700 a month or $8,400 a year. This was 24% gross yield. Now, the price of the property is $55k and the rent is $750 a month or $9,000 a year which is a 16% gross yield.



My worst property cost $55k (2 years ago) and was rented at $850 a month or $10,200 a year. This was a 18.5% gross yield. Now, the price of the property is $110k and the rent is the same, which is a 9.3% gross yield.



I anticipate yields to continue to fall significantly in the (near?) future. I will want to extract this equity.

 

[Darr]

Hi All-



I would like to follow-through on my previous post about the danger of leveraged purchases right now.

Not only do I support what Rickson previously said about low leverage (50% Max), I wholeheartedly believe that `all equity` purchase should be the rule, if possible to reduce your overall portfolio leverage ratio.









Below the headline news, mortgage rates are historically at the highs versus bonds of a similar duration. Lenders are increasing their margins on a spread percentage basis. They know what`s coming and are quietly hedging themselves. Look at the 25 year mortgage rate spread as a clue.







Rising rates are not your biggest risk. You can always stress test your cash flow and asset price delta for a given change in yield. Your greatest risk is the one you don`t expect and Rickson nailed it when he said: When the lender loses confidence, the rug can literally be pulled from under one's feet.






YOUR GREATEST RISK IS: NOT HAVING YOUR MORTGAGE RENEWED!









Banks are fully aware that the US, UK and Japan have past the point of no return. These economies cannot be repaired. Consumer spending represents in excess of 70% of western GDP's which leaves very little in domestic manufacturing. Both Consumers and Governments are maxed-out in debt.









Consequently, the `powerz that be` have two choices, either:







A) A) Deflate / deleverage ( spending cuts, rising taxes) or


B) B) Inflate the money supply (increasing budget deficits).







Choosing A to the extent of eliminating the deficit will cause a Greater Depression worst than 1930 because of the imbedded debt in today's system. This will collapse all banks, over leveraged citizens and government revenues. It`s political suicide at best and most likely would trigger insurrections reminiscent of 1789.








Choosing B is more palatable. Money is printed to pay for increasing deficit spending to calm the masses while kicking the can down the road. This further dilutes the purchasing power of the currency and creates inflation.








Unfortunately, global creditors have now lost confidence in the (big three) western nations and are no longer purchasing their bonds (debt). Central banks (FED, BOE, BOJ) are forced to be buyers of last resort thus monetizing the debt even more. These three are buying each other's debt in a "Ponzi like" game of musical chairs. A run on the currencies will surely ensue pushing one or more of these economies into hyperinflation. Hard asset prices will rise and real estate is among one the best investments you can own in this scenario as long as you can hold-on to it while weathering the storm. Problem is that banks don`t lend in a hyperinflationary environment and will prefer to short squeeze your loan, forcing a surrender of your asset into stronger hands and having you rent.









Be careful about how much debt you`re taking-on because mortgage renewal is totally subjective. Anyone that`s highly leveraged today with desirable R/E assets will unquestionably be a target and potentially be taken to the cleaners.














Notwithstanding:


For those of you just starting out in life your strategy should be different as follows:






With no foreseeable future assets to seize other than your down payment, maximize your leverage and go long the term (10 years). In other words, if you have little to lose then take a chance.






On the other hand, if you anticipate coming into/inheriting "Hard Assets" in the future, RENT and buy gold and gold stocks. You will have plenty of opportunities to buy R/E later at bargain prices in "Real" (inflation adjusted) terms.

 

[TCarter]

In scenario #1 I don't see how a third of his mortgage payment went towards the principle. The way I understand mortgages less than 10% of his monthly payments would have gone towards the principle for the first 5 years. Is this the result of a low interest rate or is his mortgage structured differently?

 

[RedlineBrett]

Depends so much on the needs of the investor.



I would put my retired parents in a cash flow rich, equity poor investment structure. I choose to put my own money in the opposite. I generate income outside of my investments to keep the lights on at my house, and so I can take on risker investments that do not throw off a lot of cash.



Many retired people do not have enough income and need to plan to draw down on their investment principal until they 'plan to die'. This is at the expense of enhanced overall returns through greater leverage.



Also, the investors whole portfolio must be considered too.



Different stokes for different folks I guess.

 

[Thomas Beyer]

[quote user=RedlineBrett]Many retired people do not have enough income and need to plan to draw down on their investment principal until they 'plan to die'. This is at the expense of enhanced overall returns through greater leverage.

Also, the investors whole portfolio must be considered too.

Different stokes for different folks I guess.
Very well said, Brett !

I was not saying the one leverage level is better than another ! It is up to the investor indeed !

Hence I posited it as a question, not a statement !

The point is that you must decide, as an investor, what is more important to you: regular cash-flow (with lower risk and a likely far lower overall return) or a high cash-on-cash ROI over a 5 or 10 or 20 year period (with possibly higher risk and no or far reduced cash-flow).

 

[Thomas Beyer]

[quote user=TCarter] In scenario #1 I don't see how a third of his mortgage payment went towards the principle. The way I understand mortgages less than 10% of his monthly payments would have gone towards the principle for the first 5 years. Is this the result of a low interest rate or is his mortgage structured differently?
In scenario #1 the mortgage is $3M, 25% cash down ($1M) for a $4M asset.

Mortgage paydown is indeed about 10% .. of $3M.

Mortgage paydown is a crucial element of the overall return equation. Therefore, that portion of the equation is lower, both in relative and in absolute terms, if one has a high down payment and a smaller mortgage !

 

[TCarter]

I was referring to the amount paid towards the premium over five years , I thought it wouldn't as high but I entered it into an amoritization table and found that the 300,000 figure is about right. This calculator actually gives a higher number, roughly 360,000.

http://www.bankrate.com/calculators/mortgages/amortization-calculator.aspx

 

[Thomas Beyer]

[quote user=TCarter]In scenario #1 I don't see how a third of his mortgage payment went towards the principle
I assumed 10% of the $3M mortgage is paid off in 5 years, i.e. $300,000, which is a rule of thumb on a 25 year amortization. In today's low interest rate environment it is actually higher, more like 12-14%, or about 25% in 10 years.

So if you invest with 25% down and have your tenant(s) pay down the mortgage 25% in 10 years you made 100% on your money .. not counting any equity upside or cash-flow ! Add some equity upside, say 2-3%/year or 25% in 10 years that is another 100% on your money in 10 years. 200% in 10 years - try that in the stock market with consistency !