What real estate success looks like

So far on this blog, we’ve spent most of our time talking about buying your first building. But what does the end-game look like?

One thing to understand about real estate is that there’s literally no limit to how big you can get. If you’re disciplined about saving money and re-investing, you can keep growing your asset base for your entire life. Since the market is so large (trillions of $$$s), there is nothing stopping you from accumulating hundreds of millions of assets… again, if you’re ambitious and disciplined.

But what about a normal person or couple who just wants to ensure financial security in retirement? Maybe a pair of teachers. What does success look like for them?

Well, imagine they spent their 30s and early 40s saving up the dough to buy four fourplexes. Assume they ran the buildings competently and never missed mortgage payments. Assume also they never refinanced.

What will their financial life be like at 65-70? Obviously, the value of the dollar will have changed. So let’s just assume that inflation effects everything equally (revenue and costs), so that we can think about things in terms of today’s dollars (not 2045 dollars):

  • They own 16 units
  • Mortgages have been paid off
  • Each fourplex generates the equivalent in 2012 dollars of $4,000 / month gross, or $3,000 / month net.
  • So they have the equivalent of $12,000 per month or $144,000 / year net coming in
  • The assets themselves are worth, say 10x gross, or $480,000 each
  • So the total asset base is worth $1.92MM

Even if these people didn’t save a penny after buying the apartment buildings, they are going to retire comfortably. If they did the smart thing, and contributed to their IRAs, etc., then they are going to be worth well into the $2MMs (in 2012 dollars), maybe more. They’ll also have some money coming in from social security plus any pensions from their jobs. So their income is probably going to be around $200,000 total.

Can they charter jets to Tahiti? No. Do they have servants? No. But do they have a wonderful, care-free retirement plus the ability to  leave something valuable to their children? Yes they do. The seeds they planted in their 30s and 40s grew into a stable financial base for the rest of their lives and allowed them to leave something valuable to their children. And that’s not so bad…

Mortgages: Borrowing to save

With a mortgage, you borrow to save. Sounds weird, right? Let’s take a look.

Do you know what actually happens with a mortgage payment? Sure, you send it off to the bank each month (or, more likely, it’s deducted from your bank account automatically). But do you know what’s really going on?

The easiest way to understand what happens with a mortgage is to look at what’s called an amortization table. Here’s an example of an amortization table for the first ten years of a $500,000 mortgage fixed at 4% for 30 years, with a monthly payment of $2,387.08:

Let’s break this down column by column. The “Year” column, on the far left, is obvious.

Principal” refers to how much of the loan you’re actually repaid in the given year. So out of the $2,387.08 x 12 months = $28,644.92 you paid the bank in 2012, $8,805.18 went to reduce the amount you owe.

Interest” refers to the price you pay to the bank for using their money. Of your $28,644.92 paid for 2012, $19,839.74 was interest.

Total Payment” is just that – the total paid each year. Because your mortgage is fixed, you know what your payment will be every year for 30 years.

Finally, the “Balance” column is the total amount still owed on the loan at the end of the year. So after 2012, you’ve reduced the amount you owe by $8,805.18 (see “Principal” above), meaning you owe $491,194.82 of the original $500,000.

Notice that, over time, the amount you pay per year stays the same, but that the amount of that payment that is interest goes down and the amount that is principal goes up. This makes sense, right? As you pay down the loan, there’s less borrowed money earning interest, so you pay less interest and retire more debt.

So how does all of this relate to savings? Well, assume that you bought the property for $550,000, with $50,000 in cash and $500,000 of mortgage debt. Assume further that the value of the property stays constant over time. If you sold it for $550,000 after ten years, you would have to pay the bank $393,919.80 to pay back the rest of the mortgage. That means you get to keep $550,000 – $393,919.80 = $106,080.20. So your $50,000 has more than doubled.

Now, you might think “yeah, but I paid a total of $28,644.92 / year x 12 years = $343,738.92 to the bank over those ten years and all I have to show for it is a lousy extra $56,000.”

And that is why you don’t buy a single family home, but you DO buy income property. With a single family home, the $300k that disappeared came out of your own pocket! But with an income property, your tenants were paying the mortgage the whole time! You didn’t pay that $343,738.92 over ten years… your tenants did. And better yet, as we’ve seen before, the property probably wasn’t just covering its mortgage the whole time. It was probably giving you additional cashflow, too.

Your $50,000 got you control of a little business that threw off cash to you for 10 years plus also more than doubled the value of your initial investment. And all of that was without any increase in the value of the overall property… it’s just the result of how the mortgage math works.

Introduction to Los Angeles Zoning

Get it through your head: The land is important!

Too many buyers don’t understand that the land component of a property is potentially it’s most important aspect. Why? Well, buildings all fall down in the long run. But land is unchanging and often has potential.

What do I mean by potential? Well, in the absense of government regulations, you can always build a lot more structure on a given parcel of land. Buy a single family house, knock it down and building a fourplex. What stops you from doing that in LA? Zoning.

Zoning is a form of governmental regulation that determines what can be built, where.

LA’s zoning code is particularly terrible, since it was designed for a city of detached, single family homes, making it extremely difficult and expensive to develop apartments or condos, which are the kind of denser development the city desperately needs to combat sprawl and traffic. OK, lecture over.

For the purposes of the apartment investor, here’s what you need to know about the relevant types of LA zoning:

  • R1 – This is residential home zoning, but an apartment building in an R1 zone is allowed to continue to operate because it’s grandfathered in. In a way, it’s the best scenario, because you know no one can build any more apartments to compete with you.
  • R2 – Slightly denser than R1. You can building one dwelling unit per 2,500 sq ft of land. So if you have a 5,000 sq ft lot, you can build two units (provided you meet the other requirements)
  • RD1.5 – One unit per 1,500 sq ft of land
  • RD2 – One unit per 2,000 sq ft
  • R3 – This is where things get interesting. One unit per 800 sq ft
  • R4 – One unit per 400 sq ft
  • C1 – Commercial zoning; but can be treated as R3 if you want to build apartments or condos
  • C2-5; CM – Treated as R4
  • MR1 – M3 – Treated as R4

Why does all of this matter? Because a property’s value is to some extent determined by its potential. Say you’re looking at two otherwise identical single family homes on 6,000 sq ft lots in Echo Park:

  1. Property A is zoned R2. To find out how many units you could build there, divide 6,000 / 2,500 = 2 (the city always rounds down). So you could build two units.
  2. Property B is zoned R3. So divide 6,000 / 800 = 7 units.
Right now, apartment developers can afford to pay you  around $50,000 per unit for well-situated land to develop. So the land underneath Property B is worth $350,000 by itself (ignoring the value of the home). By this measure, Property A’s land value is obviously only $100,000.

 

So identical pieces of property can have vastly different values due to their zoning. And that’s why you pay attention to boring zoning codes.

 

Want more info? Here’s a Zoning Summary.

Legalese: I’m not an architect or a land-use attorney, so this is not architectural or legal advice.

Buying a single family home for investment purposes

Recently, I’ve had some people approach me about buying houses for investment purposes.

The concept is simple: There are loads of people out there who either can’t or won’t buy a house right now. They choose to rent (hopefully from me!) instead. But there are lots of people trying to sell their houses… both individual owners and also banks (which got them through foreclosure). So there is an opportunity for investors with cash and / or the ability to get mortgages to  step into the breach, buy unwanted houses, and rent them to appreciative renters.

Depending on the neighborhood, you can even find individual houses that, as rentals, not only cover the mortgage but also yield some cashflow. (That’s pretty much all the evidence you need that it’s time to buy real estate.)

Let’s do some math on a real, sample property in Echo Park to find out how the numbers work. Here are the facts about Property A:

  • Single family home
  • 2 bed / 1.75 bath, plus bonus studio
  • 860 sq ft home on 4,00 sq ft of land
  • Priced at $400k

Say you buy it for $380k as an investment property. Here’s how the deal works:

  • Put down 20% (banks require at least that much for an investment property these days), or $76k
  • Borrow $304k at 4.5% (interest rates are a little higher for investment properties) fixed for 30 years
  • Mortgage payment of $1,540 / month
  • Property taxes of ($380k x 1.25%) / 12 months = $396 / month
  • Add in $100 / month for gardener plus another $100 / month for insurance
  • Total costs of $1,540 + $396 + $100 + $100 = $2,136 / month
  • Rent the house out for $2,400 (you might do better, but let’s be conservative)
  • You’re netting $264 / month or $3,168 / year in cash
  • Plus, you’re reducing your loan balance by about $400 / month or $4,800 / year of your mortgage (this goes up gradually over time)
  • So your total return on your downpayment is ($3,168 + $4,800) / $76,000 = 10% in the first year

And that’s not all. You’ve got a fairly highly leveraged investment. If the property appreciates by 1% over the first year, the value of your equity will grow by an additional $3,800 (ignoring transaction costs involved in actually selling).

One caveat: As previously discussed here, it’s a little risky to depend so heavily on one tenant to make your mortgage payments. You need to be in a position financially where a month or two of vacancy won’t kill you… otherwise, buy a fourplex.

Interested in buying the property above or one like it? Have $75-100k in the bank and decent credit? Get in touch!

What I want from this blog: a community

Right now, this blog is very much a one-way conversation: I write about income properties and you read about them. It’s kind of like this:

From benhusmann (on Flickr)

But I want more. I want this to be the kind of place that like-minded people come to discuss Los Angeles real estate. I want it to be like a virtual version of my favorite restaurant, Madame Matisse, where I have breakfast a few times a week and talk to the staff and the other customers.

I’ve already met some of the people who read this blog regularly (Hi Larry! Hi Jason!) and I know they have tons of real estate knowledge they can contribute. And I’m betting there are a LOT more of you out there with wisdom to share.

And if you’re not an expert, you have something maybe even more valuable to bring to the community: questions. It’s pretty easy for me to forget that most people only buy real estate a few times in their lives (if ever). So sometimes I gloss over things that seem obvious to me but which are totally NOT obvious to new or potential investors. That’s where you new people come in… I need you to tell me what isn’t clear, what’s confusing, what you want to learn more about.

So take the leap. Post a comment. Ask a question. Disagree with me. And let’s turn this into an awesome community full of smart people figuring out how best to secure their financial futures through investing in real estate.