Real Estate Investing Versus The Stock Market : Part 1

I have not done this for a while so it’s time to do it again.  Let’s look at real estate investing versus the stock market.  You may want to get comfortable and get out  a calculator to follow along.  Part 1 isn’t  a short post.  But when it comes to your retirement, shouldn’t you invest a few minutes to see whether you should leave that $35,000 in the stock market or to put it in rental housing?

OVERALL SCENARIO
Let’s say you are 45 years old with a plan to retire in September of 3034 at 65 years old.  You are maxing out your IRA contributions every year (Roth or Traditional, I don’t care) and/or are using your employer’s retirement plan.  Still, you have extra monies that you invest passively in the stock market in some mutual fund that isn’t giving you the results you are after or desire or heck, you just want to diversify.

In our scenario about to unfold you will need approximately $38,500 in cash to pay for the down payment and closing costs. The mortgage company will insist that this not deplete all your “on hand” cash so you’ll still need another $6,000-$8,000 in reserves easily accessible.

THE INCOME PROPERTY
First let’s look at the income property we are going to acquire.  It’s a “typical” lower bell curve house in Johnson County, Kansas, a “better-off” suburb of Kansas City, Missouri. The house would most likely be in Overland Park or Olathe.  Quite possibly it will be a 3-4 bedroom, 2-2.5 bath split level home with a 2 car garage in either the Shawnee Mission or Olathe School Districts. Good school districts. We’re also going to say, for the sake of this argument, that the home is a turn-key investment property that is professionally managed by us.

The negotiated purchase price will be $175,000 plus roughly $3,500 in closing costs since you will be leveraging with a 30 year mortgage at 5.75% with 20% down ($35,000) and, hypothetically speaking, closing on August 30, 2014 making your first payment due on October 1, 2014.  Therefore, your house payments will be $817.00 for principal and interest only.

THE INCOME
A house such as described should rent for about $1,575 all day long with good demand and, in our current rental market, with less than 30 days of vacancy.  That translates to a $18,900 a year in income. No.  You do not get to spend all that!  Because first, there is vacancy.

THE EXPENSES
Our Kansas City area property management company, KCPropertyManager.com has over 200 homes in our portfolio and we can tell you that on the Missouri side vacancies run about 7-8%.  On the Kansas side, at least right now, vacancies are running closer to 3-4%.

But that is not all, we cannot forget about taxes, insurance, repairs, sinking fund (for future repairs like roofs, appliances, etc, and fees for utilities and professional property management as well as any other miscellaneous costs.  Now, I can break all those down for you. However, as a Kansas City real estate agent who helps real estate investors every day, I can tell you that rental property expenses run anywhere from about 30-34% for self-managed homes to 35-40% for professionally managed homes.  Sure, any particular year can be slightly better or worse, but those are the averages I’m finding here in Kansas City.  (It’s also a function of what neighborhood you are in…but that’s a blog post for a whole other day.)

CASH FLOW BEFORE TAXES
I have written many times about the 4 Benefits of Real Estate Investing  so you can go back to those posts to see the details. CFBT = NOI (net operating income) – Annual Debt Relief.  For our example Kansas City rental property here the Cash Flow Before Taxes is roughly $1,536/yr.  Or a whopping $128/mo.  Vacation baby!

Uh, no.  The cash for this particular house is enough to cover all the expenses and build a very modest reserve as time flows by.  But you are not going to Europe for a month with the cash flow.  We’re talking about Buy & Hold Retirement real estate investing here.  Not cash flow hunting.  If you want cash flow, we need to either put more money down or look over to the Missouri side at a lower price point.  But then you’ll lose much of benefits 3 & 4 that are still to be discussed.

After 20 years of this your income property would have generated $30,720 of cash flow benefits (before taxes).

PRINCIPAL REDUCTION
Ah, yes.  My favorite benefit of real estate investing.  Each month your tenants pay their rent they are also paying down your mortgage!  Your rent house, the one not kicking off very much cash flow, after twenty years has a principal reduction, courtesy of your tenants over the years, of $65,571.

That’s more than twice your cash flow.  Now we’re getting somewhere.

TAX BENEFITS
This one may be tricky for me to extrapolate 20 years without spending my life writing about it.  But the first year tax benefits should be about $350.  As a reminder Tax Benefits are

NOI – Interest paid (per year) – Depreciation (per year).

Suffice it to say that with each passing year your CPA will make sure he is reducing your overall tax burden as much as current tax law will allow.  You can always subtract the interest and there is a specific depreciation schedule that extends over 29.5 years.

For our purposes in this entire argument, I’m going to pretty much null this investment property benefit.  Oh, make no mistake, it’s real but for the purposes of our argumentative experiment we’ll just consider it gravy.

APPRECIATION
Did you live through 2007-2011?  Here in Kansas City it was more like 2008 – 2012 when all you east and west coast readers caused our money supply to just stop!  So appreciation is not a God given right when you own real estate of any kind.  We learned that up close and personal. Right?

Historically, however, we know that real estate tends to be a great hedge against inflation.  Here in Kansas City in Johnson County, Kansas real estate prices tend to float just above inflation.  For  our argument here, we’re going to say that our economy for the next 20 years will be pretty much like it is today.  (Quit laughing.  I cannot tell the future any better than you can. I know darned good and well there will be rises, dips and the unforeseen.)

So, with all that said, let’s say that the income property in question appreciates at 3% per year.  That would be a fair slow growth number for the Kansas City area.  (Check out the last 10 years on average.)  After twenty years, our rent house that you purchased for $175,000 would now be valued at $316,000.  That’s a gain of $141,000.

TOTAL BENEFITS AFTER 20 YEARS
Cash Flow Before Taxes     $30,720
Principal Reduction     $65,571
Tax Benefits     n/a
Appreciation     $141,000
Total Benefits   $237,291

I HEAR YOU!
I already know some of your objections. So let’s do it.  (Even while conveniently forgetting that rents quite likely go up over the years…but we’ll not even count that…just like the tax benefits.)

Additional repairs.  My calculated expenses ratio accounts for the property to pay for most of is own obsolescence and make-ready turn overs.  But housing can take hits planned or otherwise.  So let’s subtract an additional $8,000 for a roof, $4,500 for heating and a/c, $800 for a water heater and $5,500 to fix a bunch of wood rot and get a good paint job.  That’s a total of $18,800.  Heck, let’s throw another 10% on top of that and make it $20,680.

Sales costs. Well now, this could get complicated.  Are you going to sell outright, pay the capital gains and the depreciation re-capture?  Not advised.  Are you going to refinance and pull the money out to do other things like vacation, re-invest in other housing or stocks?  1031 Tax Deffered Exchange?  Or, are you going to let it go and form trust wherein you can leave this property to your kids or heirs, capital gains tax free, upon your passing?  These are all scenarios that may very well be different 20 years from now than they are today.  So I am not going to figure in sales costs…but not to worry.  I won’t figure in sales costs on the stocks and/or mutual funds, either.

THEREFORE
If you take your Total Benefits – Additional Repairs you have an Adjust Benefits Total of $216,611 after 20 years of ownership of this investment property.

PART 2 TO FOLLOW…

 Chris Lengquist
Keller Williams Realty
Diamond Partners, Inc
13671 S Murlen Road
Olathe, KS  66062
913-568-1579

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Filed under 4 Benefits of Real Estate Investing, Investment Property, Kansas City Real Estate, Real Estate Investing

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