Today’s case study came with an irresistible subject line, and before you all start accusing me of making that headline up for the clicks, it was the reader who came up with it, so shaddup.
CASE STUDY – Real Estate Regret
Hello FIRECracker and Wanderer,
I binge read your entire blog! I am also an East Asian female who used to work in IT. And it’s really great reading about you guys! Finally I feel represented in the FIRE space!
I’ve been pursuing Financial Independence since 2015, but I only started reading your blog 1 month ago, since I am based in the US.
I am 30 years old and live in Boston, MA, USA. I work as a real estate agent and work 7 months of the year and travel for 5 months of the year. I only live in Boston during the spring and summer, and travel to warmer, cheaper, places during Boston winter.
My parents did not push me to buy properties, I did it on my own because I work in the field. But buying properties make my parents proud so I keep doing it. My parents are very intelligent and I knew that I could never surpass them career-wise, so I turned to real estate, because they know nothing about real estate and I thought I could forge my own path. Also, I HATED working in IT, I eventually got depression and mild back pain from sitting in front of the desk for 8 hours a day.
I enjoy fixing houses and dealing with tenants, but after reading your blog, I’m starting to regret making my real estate decisions.
I was wondering if I should sell my property OR keep my property and refinance it.
I have a long-term boyfriend, but I did not put his income or expenses here. He likes to work, his family is well-off, and he’s not interested in FIRE, and I’m fine with that. We keep our expenses separate. I do not want to have children.
Net Annual Income:
$25,000 a year (net) from working 7 months a year
I like my job, and I can work the other 5 months of the year if I need to. I can also travel and work online if I need to.
$1500/month (I pay $830/month in rent)
1. Investment Condo #1 – bought for $290,000 in 2016.
Down payment + all expenses was $70,000)
Now worth $380,000 (after deducting all fees).
3.725% interest rate 30 year fixed
(I am refinancing to 2.75% interest – 30 year fixed interest rate this month, not sure if I should go through with it)
$375 HOA Condo fees
Tenants pay me $24,000/year. I increase rent by 2% per year + increase in condo fees.
$4800/year cash flow after deducting everything including possible maintenance costs, tax, mortgage, Condo fee, etc
$5400/year pay down equity – (tenants pay down my mortgage)
$5700/year in equity (Assuming a low appreciation of 1.5% per year)
I’m thinking of selling the condo now, but the condo is in a good location and my tenants are great (also the Boston market appreciates a lot per year – usually much more than 1.5%)
I do think the condo will keep appreciating despite the Coronavirus because it is located 5 minutes walk from 3 subway stations
The proceeds of the sale of this condo will not be taxed, because of the US tax code.
2. Investment Condo #2 – Condo bought in 2020 for $370,000. I don’t want to sell this, but if I have to, it can probably sell for $380,000 after deducting transaction fees.
($90,000 total cost including down payment + bank and lawyer fees + renovation costs + misc costs)
Condo is a 15 minutes walk to Harvard University, and I thought it would appreciate due to the location. The condo interior was originally very shabby but I hired contractors to renovate. There are no exterior issues.
$283 HOA Condo fees
rented for $2150/month ($25,800/year).
3.5% interest rate
$4800/year cash flow after deducting everything including possible maintenance costs, tax, mortgage, Condo fee, etc
$5400/year pay down equity
$5700/year in equity (Assuming an appreciation of 1.5% per year)
3. $30,000 in Vanguard Total Stock Market Index Fund (retirement account)
4. $5,000 in Cash
5. I have no debt other than 2 mortgages
My question is:
1. Should I sell Condo #1 and invest the proceeds?
2. Or Should I refinance Condo #1 and have the mortgage lower by $100? (This costs $3500 added to the mortgage)
OK so today is a little different, in that RealEstateRegret’s not asking me to do a FIRE analysis. Instead, she’s asking me to go over her real estate holdings and what to do (if anything) about them.
Now, it may not surprise you to know that we are not the most enthusiastic real estate investors in the planet. In fact, it’s important to note that we have owned precisely ZERO properties directly. And the reason for that is that we believe, after a careful examining of the facts and, more importantly, the math, we believe that for the vast majority of amateur real estate investors, owning a property directly makes no sense. Instead, we choose to own real estate in the same way that we own stocks: by indexing it. We use a broad-based Real Estate Investment Trust index ETF called XRE, which owns a wide swath of both residential and commercial real estate, collects the rents, and distributes it back to its shareholders (me). Right now, XRE is paying around 5.5% yield, which is pretty sweet considering I don’t have to swing a hammer or (shudder) interact with tenants.
So when we look at RealEstateRegret’s properties, we’re going to be comparing them to that benchmark. Can it beat a simple REIT? If yes, then great! Stick with it! But if not, then why are you doing all this work managing your property if the money could perform better in a REIT with zero effort?
Get it? Got it? Great!
ROI vs ROE
The thing about real estate investing is that it’s not that simple to determine how well a property is performing. Unlike an ETF, where you can just calculate its yield by taking its annual dividend and divide the stock price. Properties are a little more complicated.
After years of travelling and speaking to many highly successful real estate investors, I’ve come to realize that there are 2 key metrics potential landlords look at when they consider buying a building.
The first is ROI, or return on investment. Return on investment takes the after-expenses net cash flow and divides it by how much you actually paid for the property. This metric is a bit of work to calculate because you have to know ALL the monthly expenses that would be incurred, including property taxes, maintenance, and of course, your mortgage.
So say a property costs $200k and you can rent it out for $1500 a month. You’d figure you could just take one number and divide it by the other, right? Not so fast. You have to take into account the mortgage, and therefore how much of your own money you actually put in.
So lets say you put in 20%, or $40k. The resulting mortgage, assuming a 30 year term @ 3.5%, costs $720 a month. Add in maintenance, property taxes, land transfer taxes, maintenance, and the monthly cost becomes about $1000 a month. So that means that after expenses, your net cash flow is $1500 (rent) – $1000 (expenses) = $500 a month. But you’ve only put in $40k to earn this income, so your ROI would be $500 x 12 / $40000 = 15%. This would be considered a pretty attractive investment property to buy. Most real estate investors wouldn’t touch a property if they can’t get at least 10% ROI from it.
And secondly, we have ROE, or return on equity. Return on equity is calculated similarly to ROI, in that it takes the net cash flow of a property and divides it by the equity you own in that house. The big difference is that while ROI is determined at the time you buy the property, ROE changes as your equity in the house changes over time. The two biggest factors that effect ROE are your mortgage getting paid down (which increases your equity), or the house appreciating in value (which also increases your equity). Interestingly, an increasing equity in your house combined with a flat rental income actually has a negative effect on your ROE.
Let’s take that $200k house from the previous example. Using the numbers above we’ve calculated the ROI to be 15%. But fast forward a few years, and let’s say the mortgage being paid by the tenant increases your equity in the house by $20k. Simultaneously, the house appreciates in value by $40k to $240k. So that means your new equity in the house is now $40k (your down payment) + $20k (mortgage payments) + $40k (house appreciation) = $100k. If your rent hasn’t changed, that means your ROE is now $500 x 12 / $100000 = 6%.
Bizzarely, this hypothetical house is now performing worse than when you first bought it. This is because now, you have far more of your money tied up in this house than you did before, and yet you’re only earning the same amount of rent.
How Professional Real Estate Investors Manage Their Properties
Usually when I refer to “real estate math” on this site it’s in a derogatory way, and that’s because the vast majority of people investing in real estate don’t know how to run the math on an investment property. But over time, I’ve met and gotten to know professional real estate investors who manage dozens or hundreds of properties, and have made multi-millions on those deals, and I now realize that there is real estate math that helps you make good decisions. The thing is, those decisions can be wildly counter-intuitive.
ROI, which is the initial return on investments after expenses, is what they use as a guide when negotiating the terms of their mortgage, what contractors to use for maintenance, etc. It also guides them in calculating a price they are willing to pay for a property. The name of the game here is to keep your expenses and your purchase price as low as possible so you can bag a double-digit ROI.
And ROE, which is your return on equity over time, is what they use to determine when to remove equity from the property. That’s right, remove equity. Because if your property appreciated by $100k, yet you’re earning the same rent from it, it makes no sense to leave that equity in there. So rather than gradually pay off the mortgage, they will take out an interest-only HELOC, loan the money out to themselves, thereby reducing their equity on the property, and then take that loan and go invest in another property, or the stock market, or whatever.
This part is very counter-intuitive to a lot of people. Nearly all personal finance literature states that you should pay down your loans as quickly as possible. But for professional landlords, it actually makes sense to be permanently in debt. They see too much equity sitting inside a property as “dead money” since it’s not earning them any additional income. By loaning it out to themselves and reinvesting it in another property, they take that “dead money” and turn it into “live money”.
Investment Condo #1
So now that we understand the metrics professional landlords use to evaluate their properties, let’s see how our reader’s properties stack up.
Investment Condo #1 was purchased in 2016 for $290,000. Her tenants pay her gross rent of $24,000 a year.
Now let’s calculate her ROI. After expenses including mortgage, HOA, and taxes, she nets just $4800 a year cash flow. But she initially put down $70,000 to purchase this place. So that makes her ROI $4800 / $70,000 = 6.9%. That’s not actually too great, but it does beat a REIT paying 5.5%.
Next, let’s figure out her ROE. The condo has appreciated in price nicely to $380,000. She also indicates her remaining mortgage balance is $219,000. That means her equity stuck in the condo is $380,000 – $219,000 = $161,000. So that makes her ROE $4800 / $161,000 = 3%. Dang. That’s now much worse than a REIT.
Investment Condo #2 was purchased this year for $370,000. She is currently renting it out for $25,800 a year before expenses.
Let’s calculate her ROI. After expenses, she is again netting $4800 a year from her tenants. But because of the renovations she had to do to fix up her property when she bought it, she ended up putting in $90,000. So that makes her ROI $4800 / $90,000 = 5.3%. A little under a REIT.
And finally, her ROE. Because she bought her condo this year this number isn’t going to be all that different from her ROI, but she notes that should could likely sell it for $10,000 more than she purchased it for, probably from the value she added to it while renovating. So her ROE would be $4800 / ($90,000 + $10,000) = 4.8%. Again, still under a REIT.
What Should RealEstateRegret Do?
So what does this tell us?
Investment condo #1 had an OK initial ROI, but capital appreciation and the mortgage being paid down has eroded her ROE to only 3%. You can make more passively with a REIT.
So as counter-intuitive as this is, not only should she refinance her mortgage to a lower interest rate (if she can), but she should take out an interest-only HELOC and get her equity out of the condo. Lenders in the US will allow you to have a maximum LTV (loan-to-value) ratio of 80%, so if she can get her equity in the condo down to 20% of it’s current value by HELOCing it out, that would bring her equity down from $161,000 to $72,000, and that would bring her ROE back up to 6.7%.
As for investment condo #2, I’m not too excited about it. I think she purchased it at a price that was a little too high, yet after expenses she’s only making as much as condo #1. As a result both ROI and ROE are below the returns on a REIT. So normally, the logical conclusion would be to sell it. Only she just bought it this year, and I know transaction costs would likely leave her at a loss. So what can she do?
The ROE number in this condo isn’t the problem, her ROI is too low. Her ROI on Condo #1 was 6.9%, so if we want Condo #2 to perform at the same ROI as Condo #1, we need to get her net cash flow up to $90,000 x 6.9% = $6210 a year, either by increasing the rent or reducing your operating expenses. If she can’t figure out a way to do that, then it doesn’t make sense to keep owning this one.
I think if this analysis shows us anything, it’s actually really difficult to make money being a landlord. Not only do you have to be good with finding and keeping tenants, you have to be handy and able to fix things yourself (or know someone who is), and you have to understand how to use and keep debt properly.
Right now, RealEstateRegret is making a total of $4800 + $4800 = $9600 a year from her rental income net of expenses. But $161,000 (equity in condo #1) + $100,000 (equity in condo #2) = $261,000 in equity is being used to make this happen. Unless she sells, increases rent, or HELOCs that money back out, it’s stuck. That means right now she’s making $9600 / $261,000 = 3.7% on her money.
By contrast, FIRECracker and I own a combined total of $50,000 in XRE. That fund pays me about $2700 a year. That’s a return of $2700 / $50,000 = 5.4%. And I don’t have to do anything.
So that’s my analysis. What do you think RealEstateRegret should do? Let’s hear it in the comments below!
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