SELF HELP 25
How To Invest In Real Estate: Cash On Cash Returns
This newsletter is my process of writing a self-help book, tentatively titled How To Make Money: Financial Advice For Poets.
The purpose of this newsletter is always to be useful.
I got such a great response to Sunday’s newsletter on being cancelled that I decided to write about something really boring today: cash on cash returns.
This is my 6th letter (out of 25) about real estate. Here are the others:
How To Invest In Real Estate for Appreciation
How To Invest In Real Estate for Cash Flow
How To Invest In Real Estate the BRRR Method (my most popular post)
How To Manage an AirBnB (subscribers only)
Most of this comes from interviewing small time owner/operators. Sometimes I refer to them as single-digit millionaires. They are the most unusual group of people I’ve ever spoken too. Individualistic to a fault. Often moody and incapable of working for others (or even with others). Loners, contrarians, and autodidacts. A fair amount of what they have to say is wrong.
Cash on cash returns is a common metric used in place of return on investment to buy and sell real estate. In simple terms it’s the annual profit you receive from your initial investment assuming average leverage.
For example, if you put a $100,000 down on a $400,000 property with a $300,000 loan and your profit after paying for everything including servicing the mortgage was $15,000 annually, that would be 15% cash on cash return.
Sometimes I think of it as the wish metric because it’s so frequently wrong. Sellers of real estate tweak the return by assuming the lowest rates for the buyer’s loan, and the lowest price for their insurance, ignoring altogether the very real possibility that the tax on the property might spike if based on the most recent purchase price.
The buyer wants to believe in a high return, and the bank does as well. Appraisers known for low valuations won’t find much work when everyone wants the value to come back as high as possible. To quote Cicero, “An optimistic appraiser is well fed.”1
Should you buy a property with 15% cash on cash return? Yes, almost certainly, but not because you make 15% on your money. An investment that decreases your liquidity and takes 6 years to return and 12 years to double is not the best investment. However, property prices generally increase. And even when prices are flat real estate usually keeps up with inflation. So if inflation is 1% (the central bank hopes it’s 2%) the value of the property will also rise 1%. But, and follow the math here, 1% of a $400,000 property is $4,000. That’s actually 4% of your initial investment. So now you can add 4% to your cash on cash giving a return of 19%. That’s pretty good.
But! You’re also paying down the loan. A percentage of every payment is going toward principal so you are owning more of the property every month. All of the money put into principal will eventually return to you, either when you sell or refinance. So if you’re paying $6,000 toward principal each year, a number that actually goes up because of the way loans are structured, that would be another 6% of your initial investment.
So in a very conservative case you’re returning 25% of your money. That’s a great investment. It’s not liquid, like cash or stocks, but real estate will generally sell. People have to live somewhere.
Rents go up as well. So often with real estate marketing, especially regarding commercial properties, you’ll see a chart with projected cash on cash returns rising every year. There is absolutely no need for this chart since the seller of the property is no better at predicting the future than the buyer, but we find comfort in shared delusions.
Optimism hides lies the way bushes hide stray cats.
One last thought before I put myself to sleep. If you are able to refinance the property, or if you purchased the property outright and then finance it for more than the cost of the property (people do this all the time) you can do much better. For example, the investor I wrote about who did a portfolio loan on 3 affordable properties in Jackson. It took him 5 months to put it together, and he’s only making maybe 8% (10%?) on the money now, except he got all of his money back in the loan. So maybe he’s making $900 a month but since the loan was as much as he paid for the properties it’s essentially free money. Which is much better than 25%. Though he’d have to work the same trick quite a few times for the income to be truly significant, and that’s unknown. How much is skill, how much is luck, and how much is just a bank flush with cash eager to approve any application?
I checked in with him the other day. Since refinancing his first 3 homes he’s only bought one more property which he can’t refinance because the property is too inexpensive to qualify. In order to work another portfolio loan he’ll have to add at least two more properties and he can’t find any right now. In the meantime, he’s paying interest on a big pile of cash.
“The prices are too high,” he told me. “There’s no compensation for the risk.”
The house he bought cost $30,000 and rents for $600 a month. The rent will go up, he says, when the tenant leaves, which could be imminent but he’s not comfortable evicting someone.
“I’m not a bad person,” he said. I believed him, but also, does anyone think they’re a bad person? It’s kind of beside the point.
The tax on the new house is over $1,000, which is a lot for a $30,000 home. And, in the 3rd month, the sewer line split and he had to dig the entire yard to replace the pipe, a process that cost $2,800.
Investing is about compensation for risk. Or that’s what I’ve been told. I don’t actually know anything about investing, and every investor I talk to has a different definition and a different way of going about it. Perhaps more accurately, every investor, with the exception of the truly great ones, of which there are very few, is telling themselves a different lie.
Still, the funny thing about real estate is that generally, thanks to inflation, every real estate investor looks like a genius eventually. But do you know any real estate investors? Do they strike you as geniuses?
“It just kills me that I’m not rich,” the investor told me, and I could tell from his voice he really meant it.
“Anyone who says that money can’t buy happiness has never been in love with a whore,” I replied.
I asked him what he was doing with the loan.
He said he has $120,000 sitting in the stock market. He’s made 10% on it in the last 5 months, but the stock market makes him nervous. He doesn’t like investing in other people.
In addition to interviewing small business owners and realtors I’ve been reading investment books to help me write these newsletters. Most investing advice boils down to “buy cheap.” It’s obvious, and also not very helpful. None of the other advice amounts to much if you don’t get a good purchase price. But from interviewing people it seems most of the best deals are happy accidents, like purchasing from a neighbor before the property hits the market.
It’s not hard to make money in real estate, but it’s slow, and stupefyingly dull. It’s not a lot of work but it occupies as much mental energy as a full time job. For most people it’s best done on the side. Purchase properties that cash flow as often as you can and forget about them while you run your life.
Howard Marks wrote about people trying to beat the stock market in The Most Important Thing. Full time traders will often buy a stock at 30, then sell it at 35, then buy the same stock later at 40, and sell it at 45. You can see the problem. If time is money then you want to buy and hold. Or as Warren Buffett once said, the best time to sell is never.
I find myself today, and most days, returning to the key to life, which I really think most people already know. Whenever I try to give advice, to myself or others, it winds down one way or another to the realization that all of life’s meaning comes from relationships. That’s all there is. Investing is really like life that way. Most of the time when we mess it up it’s because we’re thinking too hard.
xoxo
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Cicero never said that.
"Most of the time when we mess it up it’s because we’re thinking too hard." Love it.