Dear old grandma just died and left you $250,000 tax free. You should take it and buy yourself a slave.
No, really. An apartment building is kind of like a slave. It works for you all year without complaining. Sure, it takes up a bit of time now and then. But at the end of the year it turns over all its income to you. Not bad.
So take that $250,000 and buy yourself an apartment building / slave.
But how much income does that actually get you?
To answer this question, start out by thinking about how much building you can buy with $250k in cash. You could obviously just go ahead and buy something that costs exactly $250k and be done with it. But that probably won’t work, because… there are no good apartment buildings that cost $250k!
So you’re going to have to use debt. Right now, for a larger property (5+ units), you need to put down at least 25% of the purchase price. So the most expensive building you could buy using your $250k would cost $1,000,000. You borrow the difference between your $250,000 and the $1,000,000 price (more on this later).
Now we need to ask: What do you get for your $1,000,000? In LA right now, cap rates for small apartment buildings range between 5%-7.5%. (For more on cap rates, read this.) That means your $1,000,000 building brings in $50-75,000 per year in net operating profit (which is the total rent minus the costs including property tax but not including the mortgage).
So how much is that mortgage going to cost? Remember you borrowed $750,000. Interest rates for apartment buildings are around 4% right now. Assuming a 30 year mortgage, that means your monthly mortgage payments are right around $3,600 / month or $43,000 / year.
To figure out how much you’re going to be making on that $250,000 investment, you subtract the cost of the mortgage from the net profit, then add back the principal repayments (to account for the fact that you’re slowly repaying your mortgage and therefore gaining equity in the property). So if you stupidly bought that 5% cap, you’re netting $7,000 / year in cash, plus another roughly $13,000 in principal repayments. That’s a $20,000 return on a $250,000 investment, or an 8% / year return – still not bad.
Now if you managed to snag a 7.5% cap, you’re doing much better. Your cashflow is $75,000 in net operating profit minus $43,000 in mortgage payments, or $32,000. Depreciation probably allows you to shield $18,000 of that from any taxes (so you only pay income tax on $14,000 – see my piece on depreciation here). Add in the $13,000 in principal repayment, and you’re getting richer by $45,000 / year. That’s an 18% per year return.
So dear old grandma didn’t just give you $250,000. She gave you a slave to work hard for you every day and bring the money home to you. And that, dear reader, is a pretty amazing gift!
N.B.: All numbers above are estimates only. I’m not an accountant and this isn’t tax advice.