Your First Real Estate Investment — Often The Most Critical

Posted @ 10:04 pm - Filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Retirement

You’re so excited. The hundred grand resulting from the refi of your home is now in the bank. The kid in the candy store with a $20 bill has nothing on you. Man, you’re past ready — let’s get going. Then, you begin to start thinking just a little like Grandpa. Instead of a prudent cash reserve — you’re wanting to hold on to as much of that cash as possible. Cash has that affect on some of us, doesn’t it? Though easily able to prudently acquire three rental properties, you’ve decided to limit yourself to only two.

Why shouldn’t you do that? Because over the life of your Plan this will end up costing you somewhere around $500,000-1,000,000 — sometimes much more, though rarely less. How, you ask?

Let’s take a couple in their early 30’s planning to retire in 20 years. What’s the impact on their ultimate retirement income if their initial investment includes the extra property? It’s a property they can easily swing, and which will not in any way lower what we consider a prudent cash reserve, or what we call a Sominex account. (Ambien for those born after 1975.)

The property can be acquired for $250,000 using 10% down + 2% closing costs. It will pay for itself, but no cash flow is predicted. Since this is an analysis spanning 20 years, I’m going to include some assumptions.

1. Though history shows us otherwise, I’m only going to assume an average annual appreciation of 6%. Growth regions in the past 40 years have easily surpassed that figure, (over the long haul) but if it’s more, who’s gonna complain, right?

2. Normally, the market tells us when to exchange, but for this illustration, every five years there will be a tax deferred exchange (1031) executed — net proceeds (after 8% cost of sales) will be invested using 10% down + 2% for closing costs. Sales prices and net proceeds will be rounded to the nearest thousand.

3. Since these clients are real, and I know their combined income, I also know they will be barred from using any depreciation against their ordinary (job) income. It’s not relevant where their exchange equities land. However, for this illustration we’re starting and staying in Kansas City for the duration. I picked that region because they’re always complaining they never have huge run-ups in value during boom times. This will clearly illustrate, those run-ups aren’t necessary for the real estate investor to win in the end.

4. The loan balances will not be reduced. Interest only will be the rule.

OK, let’s look at it’s impact on their retirement.

After the first 5 years their property has risen to $335,000 — resulting in a net equity for exchange of $83,000. This results in the acquisition of $692,000 of new property.

After 10 years — Their properties are now worth $926,000 — resulting in a net equity for exchange of $229,000. They now can acquire $1,908,000 of new property.

Ready to say Uncle yet?

After 15 years — Their property values have now reached $2,553,000 — with a net exchangeable equity of $441,000. they now will acquire their final properties for about $3,750,000!

On the last day of the 20th year — Their single extra property, over a 20 year period, has grown to properties totaling $4,918,000 — with a net equity of, wait, here it comes………$1,150,000.

If they can only match the annual return of the S & P index, which for the last 55 years or so has averaged somewhere between 8-8.5%, the income from that equity position would amount to roughly (I’ll be content using 8%) $92,000 a year.

Excuse me, I’m mistaken. That should read $92,000 a year EXTRA. I wonder how many world cruises they can take with that much EXTRA retirement income each year?

Do I hear an Uncle! out there?

Principle in play: The ultimate size of the building you wish to construct will be entirely dependent upon the size and strength of the foundation with which you begin. Once you’ve laid the foundation, and begun construction, there are no do-overs.

Mistakes like laying less of an investment foundation than you prudently are able, when compounded over a long term and Purposeful Plan, can be devastating — especially when you’re about to retire, and wonder what could have been.

Now you know.

This entry was posted on Thursday, June 14th, 2007 at 10:04 pm and is filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Retirement. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.