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Your Austin Real Estate Investment and Wealth Building

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I receive regular inquiries from prospective investors about investing in real estate in Austin. At the outset I try to determine the objective of the investor by asking some questions. Usually it will be an open ended question like “Why do you want to own investment property in Austin TX?“.

Then I just listen.

It’s amazing how many prospective Austin real estate investors cannot articulate a coherent reason for their interest in investing in real estate. The responses vary from wholly uninformed dream seekers, kicking tires and “researching” on a whim (which is fine!), to incredibly informed wealth builders who really do know their numbers and what they hope to accomplish with a real estate investment over time.

It’s the latter we seek to help, though I like to think I’m always helpful and friendly to the ones with unreasonable hopes and expectations by discussing it a bit, or directing them to our Investing in Austin Real Estate page.

The most striking disagreement I have when talking to prospective investors comes about with the ones focused solely on “cash flow”. They want to buy a “property that cash flows at least a couple of hundred a month“.

I don’t personally care about cash flow, so I’m unsympathetic to this requirement. I’m not tuned in to it, because it’s not how I think about wealth building. Cash Flow is meaningless to me. Many are confused when I say this.

I just think it’s the wrong thing to focus on because that’s not what ultimately determines the success or failure of a real estate “buy and hold” investment, over time. I’ll explain further below with an actual real life example of a property I actually own.

What I do want from my real estate investment is that it produce a slow, steady, reliable increase in Net Worth over time. That’s it. I’m patient, as this is something that happens over decades, not a quick flip. I am a “Buy and Hold” real estate investor, and that’s who I specialize in helping as well. I help people seeking wealth accumulation, not income.

I don’t need “income from rent”, aka “positive cash flow” at this point. I will want that and will get it later in life, after all the real estate is paid off. But, for now, I am on a journey to cross a “financial freedom finish line”, which is that point in time at which, should I so desire, I can quit working forever and not run out of money – ever. This should be your financial goal as well. That is my hope for you.

I will in fact reach that financial freedom finish line because I’ll own a number of “free and clear” rental properties that continue to appreciate in value while also producing rental income sufficient to support the lifestyle I desire. That’s the end game. Current “cash flow” income today is not important to me because it doesn’t affect the progress toward that goal nearly as much as other factors do.

I’m building future wealth with real estate, not looking for a present income stream. It’s no different than the “negative cash flow” (if you want to think about it that way) which you invest into your IRA/401K through monthly payroll deduction or “dollar cost averaging” outside your paycheck. That’s how I think about “negative” real estate cash flow.

How I think About Money
I can’t really point to a “guru”, or say that I’m a disciple of any sort of “investment philosophy”, but I have since the 1990s read articles by Scott Burns (now retiring) and I like to catch Money Talk by Carl Stewart on KLBJ AM Radio in Austin when I can (or the podcasts). I was also profoundly influenced 20 years ago after reading The Millionaire Next Door. It’s a great book, and everyone should read it.

The result of absorbing content from these sources, and others, is that I’ve adopted “beliefs” and “money habits” that cause me to live a lifestyle well below my means, with no debt other than real estate debt. Then, I continuously plow the excess income into real estate investments that have slowly built over time, starting in 1994 with my first real estate investment purchase.

I do also pay into a tax deductible IRAs. But, mainly, because I am a real estate Broker, and a professional property manager, real estate investing has been my chosen path to financial freedom.

Unlike a lot of my Realtor friends, my standard of living does not fluctuate up in good markets when commission income increases. I drive a Jeep live in middle class housing. In good Austin real estate markets, when I earn more, I simply use it to buy more real estate instead of upgrading my lifestyle. Then when the market slows, and income drops, there is nothing to cut back on as I plan for those dips by living well below my means, seeking happiness in ways other than consumer consumption.

That’s my philosophy in a nutshell. I do splurge on vacations though. 🙂

Example of an Actual “Negative Cash Flow” Property I Own
So, let’s look at a typical “negative cash flow” Austin rental property that I own. I’ll use the “worst” negative cash flow property I have, the one with the highest negative cash flow. This is a single family home, with 12 years remaining on a 15 year note. I’ll try to make this as simple as possible.

Rent: $1,700
Payment:  $1,730 (Payment + Interest only)
Prop Tax: $570 ($6,851 annual divided by 12)
Insurance: $149 ($1,791 annual divided by 12)
Total PITI = $2,459 (PITI = Payment, Interest, Taxes, Insurance)

Gross Negative Cash Flow = $759 per month

Yikes! “Dude“, you must be thinking, “You’re terrible with money. That looks like the worst real estate investment I’ve ever seen! You’re losing $759 each month!“.

Am I?

Patience, Grasshopper. Let’s keep running the numbers. Remember, I don’t care about cash flow. I’m trying to grow Net Worth. And I’m redirecting income that would otherwise support a higher consumption lifestyle into the real estate investments, so I can grow Net Worth. So let’s see how this investment affects Net Worth.

Because I only buy real estate using 15 year loans, the equity paydown portion of  of the PITI is slightly more than half of the $1,730 PI (payment+interest). Let’s work that out, then we’ll also add Appreciation in value.

Let’s switch the numbers to annual from here forward:
($9,108) Annual cash loss ($759/mo x 12 months)
+ $9,801 Equity Paydown over past 12 months (will grow larger each year by the way)
= $693 positive added to Net Worth

What the above shows is simply that $9,801 of last year’s payment went to principle paydown, thus increased the equity in the property by the same amount, and therefore is not an “expense’ or a “cost” or a “loss”. It’s simply the moving of that amount from a Cash category on the Net Worth spreadsheet over to a Real Estate Equity category for that property. Nevertheless, it actually is “positive” by a small amount in this case.

Next we have to add value appreciation. Real Estate goes up in value, “appreciating”, generally at a rate greater than inflation. I have a column in my Net Worth spreadsheet that computes 0.375% of the real estate market value of each property I own as additive to Net Worth each month. 0.375% multiplied by 12 = 4.5%, which is the historic average annual appreciation of real estate in Texas.

In this case, the example property was worth $310,000 last year. Using the historic average appreciation of 4.5% (according to Texas A&M Real Estate Center), the value increased to $323,950, which is a value increase of $13,950.

(Note: In reality, homes in Austin appreciated at about 10% annually over the past 5 years, but investors should assume 4.5% annually over time nevertheless, as markets have ups and downs. From 2008 through 2011 our market was flat, and even decreased in some areas. So 4.5% is just a conservative static number upon which to base assumptions over decades of time)

So where does that leave us, adding back Appreciation and Principle Paydown?

$693 + $13,950 = $14,643 increase in Net Worth for the year.

In other words, owning this rental property which had negative cash flow of $759 per month, actually caused an increase in Net Worth of $1,220 per month, when properly computed in the context of “how does it affect my Net Worth?”.

I have about $150K equity in this particular property, so if I sold the property and invested the $150K in a mutual fund, could I expect a return that would equal the return on equity that the home produced as a rental property?

$14,643/$150,000 = 9.7% Return on Equity.

The return on equity will go down as the home value increases and equity grows, because rents will typically not increase enough to keep up. When fully paid off, the return on equity is a return on the full market value (less selling expenses) of the home. At present, a cash purchase of a typical rental home in Austin will generate about a 5% return. That’s actually not great, historically. But there are no 6.5% CDs available currently either, so real estate is the investment of choice for many who otherwise would prefer a “safer” investment.

In the old days, we expected 12%-18% return on real estate investing. But that was back when an 8% return was assumed on the alternative of stock investing, and fixed income investments beat inflation. Investors should be rewarded with greater returns on riskier investments, and real estate is no doubt a risky investment.

I won’t go into the debate of whether we should trust the stock market to return 8% over time anymore, but I personally trust Austin real estate more than the stock market. I do invest in both though, mainly with Vanguard Target Retirement index funds because they are “set it and forget it”, which I like.

Finally, the above does not compute in the cash value of Depreciation, which is a non-cash deduction taken on the Schedule E Rental worksheet, and thus reduces taxes owed, thus further increases the return on the real estate investment.

It also, however, ignores repairs and maintenance, which fluctuate over time (though the example property actually had no repair expenses last year). So the above is not a “perfect” example of real estate cash flow, or how it affects Net Worth. No doubt, some years produce a “loss” if major expeses happen or the market takes a downturn. But the example is meant simply to illustrate that “negative cash flow” is not necessarily a money losing operation.

And if you start accumulating 3, 4, 5+ rental homes, the wealth building starts to snowball in your favor over time as interest payments shrink, rent grows, and appreciation happens. Regardless of the cash in/out on your pocketbook.

If you are living cheap and have plenty of income and cash reserves, then, like me, “negative cash flow” won’t bother you at all as you observe what’s happening to the bottom line of your Net Worth Spreadsheet.

Make sense? Feel free to comment and disagree if you have a different point of view.

Posted by Steve
8 months ago
Steve

Steve is a Real Estate Blogger, UT Austin Grad, Real Estate Broker and owner of Crossland Team and Crossland Real Estate in Austin TX.

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Cristina Valdes - 8 months ago

Thanks Steve! I look forward to your blogs and appreciate the way you think about real estate investment. My goal is to pay off the mortgages of four rental properties over the next ten years without selling anything. I second guess my strategy regularly and there are not many people with whom I can toss ideas like this around. Your message keeps me on the right path. – Cristina

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Steve - 8 months ago

Hi Christina, thanks for your comment. Yes, sticking to a longterm plan is hard, especially as members of culture driven by consumerism and instant gratification.
Stick with it!
Steve

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Janett samons - a few months ago

Great post Steve! I’m still learning from you, while I’m trying to reach my goals. I absolutely enjoy reading all that is written on your site. Keep the stories coming. I liked it!

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Steve - a few months ago

Thanks Janett.

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Chris McIntyre - a few months ago

Steve, excellent article. Love the content and the writing style. When people want cash flow do you steer them to commercial real estate? Commercial being designed to provide cash flow as opposed to residential.

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Steve - a few months ago

Chris, for investors who want true cash flow, after backing out all of the silent costs, they just need to buy in a city other than Austin.
I don’t know about commercial, though I own some and it does cash flow because I bought it so long ago. From what I hear, Cap Rates are very low for commercial so it’s suffering as much as residential.

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Hulk - a few months ago

Steve,
I wouldn’t say I disagree with you as my wife and I have followed a very similar path to wealth creation. I’m 53 years old my wife is 49 this month and we have achieved “critical mass”, and have taken the past 6 months off to see if I’m ready to retire, and although I’m leaning towards going back to work it will be my choice if I do. My wife also does not work.

How we achieved this was working and earning as much as we could and living way below are income level. This by no means we don’t live well, we splurge on vacations and eat really good food. I invested very early in (2) 6 flat apartment buildings, the first in 1997 the second in 2004 by using equity in the first for the down payment on the second.

Although I worked a full time job the entire time till just recently we never hired people and did all the work ourselves. It helps that I can fix anything, plumbing. Electrical, appliances etc, self taught but do have an EE degree. I’ve also been a very active investor in the stock market, both by maxing out tax advantaged accounts and a non tax advantages brokerage account.

The only thing I would add is if conditions change in the real estate market one is in, and you are not ready to move from that area, the goals could change as well. Up until the real estate crisis in 2008-ish we took the same approach as you, to not worry so much about cash flow but to build wealth in the properties.

However we are in a major metropolitan area of the country that has not come out of the crisis very well and definitely not like Austin, Scottsdale and others. We are still sitting below the 2006-2008 highs. And the growth is anemic to flat.

However we have really good cash flow because we’ve owned the properties for quite sometime and have low interest loans. Therefore under these conditions, we are no longer trying to build additional equity in the property, as it quite likely to remain flat or possibly go down.

This changes things to where now all we care about is large positive cash flows, and because we are very conservative with our money we can either drive that cash back into our other savings investment vehicles or if I decide not to return to work we can use that cash flow to cover 1/3 of our annual expenses.

The only point I’m making is when the asset is no longer appreciating and there is a chance that you can see the property lose value over the long term and you are not ready to sell then cash flow becomes everything.

On the other hand if we were ready to move we’d sell the buildings to get as much equity as possible, move to an area of the country that has long term growth prospects, like Austin and invest in real estate.

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Steve - 4 weeks ago

Thanks Hulk. Great success story and also some good points to consider.
Steve

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