As I promised, I am going to walk through a brief financial
analysis of the home my wife and I bought in January of 1996 and sold in
September of 1998. The property was located in Belton, Missouri, a suburb of
Kansas City. The property was a three bedroom, two car garage, split level
home. It is what I consider a "bread and butter" home. We
purchased the house as a closed bid with the Missouri VA. The purchase price
was $68,900 and the down payment and fees were only $1,403.
1. Net Cash Flow
We were able to rent the property for $725 per month, during
the rental period, with the exception of the last month. We received a total
of $21,750 during the rental period, or approximately $713 per month. During
the same period, our expenses (taxes, insurance, interest, repairs,
supplies, etc.) totaled $15,983, or approximately $524 per month. Therefore,
our net cash flow per month was roughly $189 per month for a total of
$5,767.
2. Appreciation
After fixing it up and renting it for over two years, our
tenants could no longer pay and we parted ways. Enlisting the services of a
local real estate agent, we were able to sell the property in less than 30
days. The gross sales price was $80,000. If we stop here, like some
books, you would think that we made a fortune on our initial investment of
$1,403.
Now let’s throw in reality. First, I had to pay the real
estate agent, mechanical fix-ups costs, taxes, and other fees. Our actual
sales price was $73, 210 and our cash at closing was $6,790. Still, that’s
not bad. The true appreciation on the house was $4,310 ($73,210 minus
68,900).
3. Equity
As we diligently paid the mortgage each month, a small
fraction went directly to paying off the principal. Remember, our sales
price was $68,900 minus the down payment of $700. Our 30-year loan was for
$68, 200. At closing, the actual payoff of the mortgage was $67,103.
Therefore, our equity was $1,097.
4. Taxes
The rental tax game is quite interesting. We bought a good
"bread and butter" house, fully knowing that it would appreciate
in value, yet at the end of each year the IRS allowed us to depreciate it
over a specified period of time (27.5 years) and using a particular method
that they have approved (modified accelerated cost recovery [MACRs]). Wow,
what is the catch here? For one thing, land is not a depreciable item, so
only the value of the house can be depreciated. Of course, you are free to
come up with a value of the land versus the property.
Any improvements, fixtures, appliances, and certain other
items can be depreciated. The other catch is when you sell the property the
government would like its temporary loan back. In other words, you are taxed
on the depreciated property at your tax rate. During the rental period we
depreciated a total of $5,801 in property, appliances, etc. Certain
depreciable items, such as the electric range that we bought were sold as
part of the house and therefore the remaining value was reduced to zero so
that these items represented a small tax loss.
As I mentioned, the long-term capital gains tax is currently
20% and ordinary gains are taxed at my personal tax rate. After running the
numbers through my fancy tax program, the entire sale resulted in a tax
burden of $1,768. If we consider the deferred taxes saved over the
30.5-month period ($5,801) and multiply by my tax rate (28%), the result is
a tax savings of $1,624 over the period of owning the property. Finally,
because I paid back $1,768, I nearly broke even, but lost $144.
My advice here is to not rely on tax advantages when
evaluating a property. However, once you purchase a property keep all your
receipts, monitor your mileage, and try to be as tax efficient as possible.
Be prepared for April 15th when you sell a rental income
property.
5. Labor, Pain, and Suffering
The late night programs and books inadvertently, or should I
say purposely, forget to tell you about the phone calls on Sunday afternoon
complaining about stopped up plumbing or an air conditioner that just went
out. The books and programs also failed to mention the late payments,
bounced checks, or tenants who purposely lie. The books and programs never
talk about the city governments who are now trying to implement fees from
landlords. The books and programs didn’t mention that my labor is free and
not tax deductible.
There is really no way to quantify a number in this
category. I’m not including, for example, the extra Rolaids and fast food
when working on the properties. I am including labor. Your time and my time
are worth something. After all, time is really more precious than money, ask
any elderly person.
To quantify this, I am placing a small value of $10 per hour
on my time. Although, this is an estimate, I estimate that during the
fix-up, management, and selling (fix-up again) my wife and I spent roughly
250 man/woman-hours on the property. Therefore, we lost a potential $2,420.
Summary
Cash flow + Appreciation + Equity +/- Tax benefits – Your
labor, pain, and suffering. For our house the equation results in $5,767 +
$4,310 + $1,097 – $144 – $2,420 = $8,610. So, with our initial
investment of $1,403, we realized a profit of $8,610 over a period of two
and one half years. Not bad, that’s well over 200% increase per year on
our initial investment.
Remember, though, real estate investing is somewhere in
between investing and starting a business. If you are not ready for
the "pain" don't expect the "gain."
