After seeing the stock market and real estate market decline so much during the financial crisis and then increase so rapidly over the past few years, many investors are wondering whether now is a better time to buy stocks or invest in real estate and which would be a better investment.
Consider the following facts about a recent rental house purchase which was purchased from a bank. The house in question was purchased in Port St Lucie, Florida and was a 3 bedroom 2 bathroom house and was purchased for cash directly from the bank (i.e. without a mortgage)
Purchase Price $50,000
Monthly Rental $950
Annual Rental Income $11,400
Less Annual Insurance $1,400
Less Property Taxes $1,800
Less Vacancies $950
Less Repairs $950
Net Operating Income (NOI) $6,300
If we assume that the property is vacant 1 month out of every twelve and that we spend another 1 months’ rent on repairs out of every 12 months, we would still net a very healthy 11.45% return. Where else can you get this kind of return on your money with very little risk? This house previously sold for almost $200,000 and buying it at about ¼ of that previously sold price has obviously significantly reduced the downside risk.
The current market value of this property is around $85,000 to $95,000. So while this investment yields a return of 11.45% I have the added luxury of knowing that there is around $30,000 to $40,000 worth of equity in this property. And considering that most rental properties in Florida sells for more than 100 times rent right now (this number fluctuates), the fair market value for this property should be at least $95,000. That is how much I would sell this property for if I were to sell it to a rent to own buyer or with seller financing.
Zillow currently estimates that the value of this property is $129,000. The insurance company has the property estimated at $125 per square foot replacement cost. Since the property is 1,176 square feet in total, that puts the valuation for replacement cost at $147,000. I think the property is worth around $95,000. Zillow and the replacement cost method are grossly overstating what the property is worth. However I might be able to sell the property for that much to an unsophisticated buyer with a rent to own lease option.
The fact that properties are selling at such a discount to replacement cost should be a huge signal to you that now is the time to invest in real estate. And that is exactly why Wall Street is doing exactly that. For the past 2 years Wall Street companies like Blackrock Capital have been buying billions of dollars’ worth of real estate all in single family houses. Arguably one of the greatest investor’s that ever lived – Warren Buffett said in an interview on CNBC last year that if he could, he would buy billions of dollars of single family homes and rent them out.
And the reason is return. You simply cannot get that kind of return anywhere else. Consider replacement cost as an example. That is what it would cost to build a new house.. The replacement cost to build is around $100 to $125 per square foot which would put the property’s value at somewhere between $117,600 and $147,000. However this is the value if the house was constructed new without the land. The lot is worth around $25,000 so the house built new would cost at least $142,600 including the lot.
Now clearly an older home like the one that I purchased is not worth as much as a newer home so we need to depreciate those replacement costs numbers a little bit. Existing homes need to be depreciated since they are worth less than new homes so the $85,000 to $95,000 is probably a healthy range for what the house is really worth. If we are conservative and assume $85,000 that is still a definite $30,000 in equity if this property was purchased for $55,000 including repairs.
At a purchase price of $55,000 that represents 54.54% return on my money when I purchase ($30,000/$55,000). In addition to this $30,000 in instant equity I also receive almost 12% annually in cash flow after all expenses as shown in the example above. And all of this is achieved without even borrowing any money (although you do need to have cash).
Imagine what the return would be if I borrowed 100% of the cost of purchasing the property and I borrowed $55,000 and gave a private lender 10% on my money.What is my return now? My monthly payment to the private lender would be $458.33 which is a total of $5,500 for the year.
If I deduct this $5,500 from the $6,300 net operating income above then even after property taxes, insurance, maintenance and repairs the property is positive cash flow. Now this is the part that gets interesting. If you have decent credit and you go to a mortgage broker and apply to refinance your mortgage they will order an appraisal. Lets assume that the house appraises for $90,000 and the lender is willing to lend 80% of that amount ($72,000). Let’s also assume $5,000 in closing costs so your net cash out refinance would get you about $67,000. But you only owe the lender $55,000. That means that after paying off the lender the $55,000 you would have an additional $12,000 cash in your pocket.
The above example illustrates a no money down situation whereby your private lender is paid back, you own the property and now your cash flow is much better since instead of paying the private lender 10% you are only paying the bank 5%. So your monthly payment has gone down to $386.51 you are even more positive cash flow and you own a property with equity of $18,000 plus you have an additional $12,000 cash in your pocket.
There is no other investment out there that can do this with any certainty.
Investing this same $55,000 into stocks would be an absurd way to invest your retirement money. I should know. I spent 12 years as a stockbroker and money manager before becoming a full time real estate investor. And I am here to tell you what many other real estate investors and landlords like me already know. The best place to invest your money is in single family rental properties. That is what I do with my money and I highly recommend that you do the same with yours.
Unless your name ends in Buffet or Soros you are much better off investing in rental properties than you are investing in the stock market. Investing is about getting as much cash flow or yield as possible, without risking your nest egg and doing so in the most secure way. And investing in property gives you the house as collateral which is one of the best forms of security that you can get. With stocks and bonds your security is a piece of paper. That didn’t work out too well for Enron, Lehman Brothers, Bear Stearns and a host of other companies that went belly up in the financial crisis. Why would you trust your life savings to a company that gives you a piece of paper (stock or bond) that says they will repay you (if they haven’t forged their books)? Investing in single family rental properties offers a decent return, safety, simplicity and most importantly you have the house as collateral.
Anything else is not investing. It is speculating. And speculating is anyone’s guess. If you are looking for a sure thing then you should go out and find a good single family rental house in a decent neighborhood that is selling for way below current fair market value. There is no shortage of properties and many bank owned properties listed on the market today would make excellent rental properties.
Buy a house and then rent it out. If you believe in the future of the U.S economy then you know that people from all over the world will continue to immigrate to the U.S. All of that immigration creates a huge demand for housing. That is why investing in rental property is as close to a sure thing as you can get in the investment world over the long term. If you want to “play the market” or speculate with your hard earned savings then my suggestion is make a vacation out of it and take the family to Las Vegas.