June 6, 2025 • 59 mins
In this conversation, Marcus Schafer and Patrick Collins explore the complexities of real estate investment, discussing whether a home is an asset or a liability, the expected returns on real estate, the risks involved, and the tax implications of investing in property. They emphasize the importance of understanding market dynamics, leveraging unique skills, and conducting thorough analyses to make informed investment decisions. The discussion also includes a real-life case study to illustrate the practical application of these concepts.
Chapters
00:00 The Allure of Real Estate as an Investment¹– recapping the highlights from our last episode
02:46 What Returns Should We Expect? – And do we see these expectations realized?
04:34 Advantages of Real Estate Investment – leverage, tax benefits, and tangible investments
10:26 Investment Strategies in Real Estate – the two major strategies we see investors pursue
12:02 The Boom and Bust Cycle of Real Estate – as a result of the combination of illiquid assets, high transaction costs, and leverage
23:09 Opportunity Cost Analysis – how and when to evaluate opportunity costs the right way
26:27 Realistic Inputs Create Realist Outcomes – better to have conservative assumptions with upside than aggressive assumptions with downside
36:33 Profitability Metrics – cap rates and price appreciation as a hope strategy
41:42 Tax Advantages of Real Estate – depreciation, 1031 exchanges, and the important distinction of investors vs dealers
48:02 Applying Theory to Practice: A Real-Life Example – Marcus talks about his recent rent vs sell analysis on his old house
Sources
¹ American Dream: Is Your House Your Greatest Investment? | Greenstream #8 (https://www.youtube.com/watch?v=z-_Eg-hHaPA)
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
(00:05):
Pat, great to see you again.
Lovely morning.
Great to see you too, good to be here.
As a quick reminder, everyone, I am Mark Schaefer, Greenspring's Director of Growth.
This is Pat Collins, our CEO.
And we are back to pick up on a conversation we had last time.
The conversation we had last time is looking at real estate.
Is your house an asset?
(00:27):
Is it a liability?
Is your house consumption or is it investment?
And when we think back to that conversation, I think one of the big surprising things thatcame out of it
was the really low return expectations for real estate after inflation.
The research shows it's about 1 % after inflation for price appreciation for real estate,which I think begs the question, is real estate a good investment when it's outside of
(00:57):
your house?
So things like rental real estate, and we thought it'd be really, really helpful for us todive into that question and how we look at it.
at Greenspring.
About 10 % of our clients do have this as an individual investment they're invested in.
So it's really common when you think about the type of people that we work with.
(01:18):
And we just thought it'd be helpful to look through it.
Yeah, I'm excited to dive into this topic.
It's, as you mentioned, we have well over 100 clients that invest in rental real estateand other types of real estate properties.
So it's a question we get all the time and we've done a lot of analysis, a lot of thinkingthrough this.
We're excited to share kind of our, hopefully our best thinking on this topic and givepeople some insights if you're thinking about.
(01:44):
either converting maybe a property you own as a personal residence to an investmentproperty or buying a property outright and renting it out.
So, excited to get into this.
Yeah, let's jump into it.
So I kind of led with 1 % real returns, which again means returns after inflation.
And then when you compare that number to what you see in kind of the public marketequivalent, the PME, so these are publicly traded REITs, real estate investment trusts,
(02:14):
and we tend to see after inflation returns of about 5 or 6%.
So significantly more than just the price appreciation.
Where's a lot of that difference coming from?
A lot of that difference is coming from the fact that you're receiving income.
Real estate investment trusts have to distribute 90 % of their income.
So it's kind of the rents, if you will, that are being kicked off.
(02:36):
And I think that's one of the really attractive things why people evaluate correctly heldreal estate is this idea of kind of passive income being kicked off.
from the portfolio.
And then building off that, what may be return expectations?
I guess this question for you, Pat, would you expect, or do you think investors expect fortargeting directly held real estate?
(02:57):
That's a great question.
I don't know.
think in working with clients over the last 20 plus years, I'm not sure if a lot ofclients think through that question, which is a really important one.
I think if you were to ask them, or at least if you were to ask me what your expectationswould be, I would think with an illiquid asset that has highly concentrated risk, I'd want
(03:18):
to have returns higher.
than equities, personally, publicly traded liquid investments expected returns I'd want tohave.
But in fact, I think almost every analysis we do on residential rental real estate, wetend to see expected returns to be a bit lower.
Now, the other side of that is that I think real estate probably as a general rule, has alittle bit more stability and price kind of movement.
(03:44):
You typically don't see every five years, 20 or 30 % pullbacks in real estate where youcould see that in stocks pretty regularly.
But it has happened and the illiquid nature of it, I think is something to consider.
But I do think when we kind of dig into it, what we're looking at is typically expectedreturns in the five to 8 % range would be a good.
(04:09):
solid return on residential real estate.
Yeah, yeah.
You bring up great points around certain risks.
Anytime you go concentrated, I view that as a bad signal for higher risk.
Well, let's maybe, we're going to dive into those numbers, how we think about buildingassumptions, how we think about assumptions on the inputs, assumptions on the outputs.
(04:34):
Maybe let's start with why people invest directly.
probably held real estate.
And what I mean by this is certain aspects that are unique to individuals that maybe thismakes a little bit more sense.
And one of the things, I guess it's a question I always ask myself when I'm thinking aboutinvesting is, do I have any specific skills or attributes that nobody else has that I am
(05:01):
bringing to the table?
Am I just bringing my capital or am I bringing something unique?
And I think this is one of the reasons why
we see many individuals kind of first dip their toes into this because they might bebringing something unique to the table that nobody else has.
So maybe just talk about some of the reasons why you see people getting into this.
(05:23):
First and foremost, I think a lot of times people get into it because it's something theyfeel like they know, they can touch, they can feel it, they can see it.
It doesn't feel like stocks due to many that haven't invested before.
Stocks might feel a little bit more like gambling or really risky.
And in their mind, gosh, how much can I lose in real estate?
Cause I own this property, I can go look at it or go walk into it every single day.
(05:46):
So I think.
That might be the beginning point part for a lot of people.
But there are some attributes of real estate that are just different than investing in aportfolio of stocks and bonds that are worth thinking through.
So the first is that real estate allows for leverage in a way that's just so differentthan stocks and bonds.
(06:07):
Yes, you can use leverage to buy stocks and bonds.
but not to the extent of real estate.
In many cases, you can buy real estate for almost 100 % of the value by just basicallygetting a loan.
So nobody that I know of are gonna loan you 100 % of the value of a stock portfolio foryou to go buy a stock portfolio.
And on top of that, you have all sorts of things like margin calls and things like thatthat people get scared of with stocks.
(06:31):
So I think that's a big part of that is you can use other people's money to buy realestate.
And that's,
that can be attractive.
Now, it's been really attractive over the past several years because interest rates havebeen so low.
You might be able to buy a real estate property for 3 % or less.
Now, that's changed here recently where the lending rates are 6%, 7%.
(06:55):
Could even be higher depending on the type of property, if you're buying an investmentproperty versus a personal residence.
So I think that's, but I think that's a really important distinction is that you don'tneed much money
to buy real estate and compared to building a million dollar stock portfolio, you got towork a long time, you got to save a lot.
You could do that over the course of a few years if you have a good enough income becausebanks will lend to you basically.
(07:19):
Yeah, which we'll talk about later, the boom bust cycle of real estate.
If it's easier to get into, it's easier to get a bunch of leverage into, tends to be morespeculative in nature.
of the things you mentioned there is just the change in mortgage rates.
And that presents a lot of opportunities where you might have an existing property at areally low mortgage rate.
(07:42):
In a sense, that might be one of your greatest assets, right?
Because it's really tough to give up.
3 % mortgage rate in exchange for a 7 % mortgage rate.
And so you might look at that and say, Hey, does this lower cost of financing give me acompetitive advantage in the industry that other people don't have?
(08:02):
That could be one thing that a lot of people are looking at saying, Hey, I have this lowinterest rate and it's especially true right now, but I think it's kind of always one of
these, components, right?
Hey, I have really good credit.
Well, I can lend to somebody that doesn't have that credit credit, right?
I can lend to somebody that doesn't have that great credit.
So there's that kind of interest rate arbitrage in a sense that might be going on as oneof the reasons.
(08:26):
Yeah, for sure.
Absolutely.
And I think there's a few others that I would touch on.
One is there's some tax benefits investing in real estate that you don't get withinvesting in other types of investments.
And we're going to dive into all these different things a little bit later.
But I do think that's a big factor is the tax code really kind of encourages real estateinvestments.
(08:50):
You can see, you you,
You look at a lot of wealthy people and a lot of people have made their money in realestate.
And one of the key attributes there is when you look and see how much they pay in taxes,it's not that much because they are figuring out ways to shield their income from tax.
They're looking at ways to defer gains on properties.
There's a lot of different factors there.
(09:11):
So I think it's just another aspect of real estate that you're not getting with stocks orbonds.
Yep.
Yeah.
I think that's, that's a great point.
I'll just name a few other ones we, uh, we thought of when we were brainstorming.
One is you're also viewing real estate investing as an occupation, right?
And maybe hobby is appropriate.
(09:34):
Maybe landlord is appropriate, but you're thinking, Hey, I have excess time and awillingness to do things.
I might have handyman skills.
I might have just an interest in some excess capacity where
Hey, why not use my money and also use my time and my energy, right?
(09:54):
I'm willing to take on headaches that somebody else doesn't want to take on, which is whythey're renting.
So that could be one.
And then also I know of, you know, in today's marketplace where you've seen a ton of priceappreciation in real estate, it makes owning a home for the next generation much more
difficult.
So we've also seen a lot of, a lot of parents
(10:15):
thinking about holding on to houses and property in a way to make sure their kids have achance to live in kind of similar lifestyles to how the parents grew up.
Yeah, absolutely.
I think when we're thinking about real estate and I think as we talk through in thispodcast, there's probably two different ways people I've seen invest in real estate for
(10:39):
residential investment.
one is, or maybe on one extreme you have just a pure buy and hold.
I'm buying a property, I'm going to rent it out, I'm going to collect the rent from it andhopefully over time I'm going to get both rent and appreciation on this property.
But I don't really have an intention of selling it.
I really am buying this as an income producing investment.
(10:59):
And then on the other side, you have what I would call maybe more value add type investorsthat are gonna buy a property hopefully at a cheap price, fixed it up.
And that's kind of where your sweat equity kind of the time energy resources that they mayhave could go into it.
I'm gonna fix this property up and then I'm going to sell it.
And the amount I put in plus what I paid for it is going to be less than what I can sellit for.
(11:23):
and that appreciation is what I'm kind of after.
And then you probably have somebody in the middle who does, buys the property, fixes itup, then rents it out and plans to hold it.
So there's kind of variations of those, but I would say that's probably the two or threemost common ways we've seen people invest in real estate.
(11:43):
Obviously there's other things you can do, like a straight buy and hold for appreciation.
you see...
there's going to be development coming into one area and you say, I'm going to try to buysome properties ahead of that.
I rarely see that that's more speculative.
But that's also a possibility too.
Yeah.
That's great.
Let's talk.
So we talked unique advantages.
(12:05):
Let's talk some of the risks about investing in real estate.
you kind of, I think referenced one, which is real estate.
You invest in what you know.
That also to me, when I'm evaluating this, when you invest in what you know, you tend toincrease your concentration.
because what you know tends to be very geographically concentrated.
(12:26):
And there's been studies out there where people tend to buy more individual stocks closerto where they live.
They know it, right?
This kind of like a common thing you'll see and that's what you know.
Well, what that means is you're kind of piling on your concentration risk to very specificmarkets, right?
Kind of thing.
Hey, where do I live?
(12:47):
That's where my job is.
Well, let me just add some additional net worth concentration right there.
And I think that's one of the things you have to be really cautious of is are you addingtoo much geographic specific risk to your total portfolio by adding real estate.
Yeah, this one is sometimes hard to see when you're in the midst of it because it's kindof like the boom and bust nature of it.
(13:15):
But I think there's examples even today.
We live outside the DC area and with a lot of the job losses happening, you could havelots of people looking to move out of DC.
DC tends to be a transient type area.
People come in to work for the government.
But if all of a sudden there's large, large job losses, you can see people leaving.
you can see property prices really dropping because of supply and demand factors.
(13:38):
There's another story that comes to mind with this.
I have a client who invested in real estate in North Dakota.
And it would be an interesting place, given that you live on the East Coast to investthere.
years and years ago, they started this kind of boom around fracking.
And there was a lot of oil that was found there, and they figured out ways to get out ofthe ground.
(13:59):
created all sorts of opportunities for people having to move there to work on these kindof, you know, these rigs and whatnot.
And they needed places to stay, they needed places, you know, for restaurants, foroffices.
I mean, all sorts of different services and facilities had to come out there.
And so, you know, he kind of lived through a boom and bust period.
And it was really interesting to see.
(14:20):
It's just, it was so specific to the price of oil.
is what drove in a lot of real estate because when the prices got too low, they couldn'tmake the numbers work for drilling.
So all of a sudden people left.
And when the prices got higher, they all came back and they all needed rental places.
it's just a, you know, that's probably an extreme example of being kind of a boom bust,but I think anywhere you're investing, you do have to be careful of is there any factor
(14:48):
that could happen that would cause people to want to leave or?
Or the other way, could work in your favor.
But I do think those things are hard to see sometimes.
Most people don't think that there was going to be massive job cuts to the entire federalsector, but it happens.
Yeah, this is the, this is the thing about risk.
It's always there, but you never see it.
(15:09):
Right.
And the reason why we call them risk factors, because it's really tough beyond the factthat we know there's an amount of risk to understand what is the actual underlying risk.
And then how do I build something that hedges against that super, super tough to, uh, todo, but you also kind of alluded to another, I think.
(15:30):
Unique.
aspect about direct investment, real estate, and that's illiquidity, right?
Because you were talking about boom and bust.
Not really that big of an issue if you can sell like this, like you can in a mutual fundor an ETF or a single stock.
But when you think about individual housing, it tends to be much more, there's a timehorizon, how long it takes to sell.
(15:56):
There's just a lot more.
hurdles to getting your money out, putting your money back into play.
You think about transaction costs.
So I think that's also, that's something that I would think really, really long and hardabout is this money is not easy to access.
And sometimes that's a good thing for certain people, but oftentimes it's not a greatthing.
(16:16):
Yeah, I've had more instances of this illiquidity issue come up over the years than I careto admit with clients because it's hard to watch.
So a few things on this, obviously, you're making assumptions when you buy a property thatyou're going to have a renter in there.
(16:36):
That person is going to rent out the property for some set amount of income.
is not coming in because maybe you have a hard time leasing it out or there's massiverepairs that need to get done.
And that means that you can't have anybody in there while those repairs are getting done.
There's still costs associated with the property at that time.
you still have, if you have a debt, if you have mortgage, you still have your mortgagepayment.
(16:57):
You still have taxes, you still have insurance, you still have utilities that you have topay.
And so all these things
just add up and obviously depending on your personal financial situation, it could bereally, really detrimental from the standpoint of having negative outflows with no
liquidity.
And then, you know, on the other side of it, let's say you've had it for a long time andyou have a lot of equity in the house.
(17:21):
Well,
There's also risks around, well, could I pull that equity out if I need to at some pointin the future for liquidity?
A lot of times that's the kind of conversation that people have.
Well, yeah, I can't sell it, but I could always get a mortgage on the property.
I have a lot of equity in it.
That's true.
But you also have to think about your personal circumstances.
I've had situations where clients are looking to take out a mortgage on it, but because oftheir personal financial situation, maybe they're not working.
(17:48):
maybe they lost their job, it's an exact time when they need liquidity, and they go to tryto get a mortgage on the property and the bank says, sorry, I don't know how you're going
to pay this back, especially if the renter might leave.
So we're just not comfortable giving you a mortgage because you don't have any income.
And so these are all things that you have to think through is that it may not seem like abig deal now, but it's kind of like when that perfect storm hits, could that be a problem?
(18:12):
And obviously, when we're talking to clients, we want to think through
What if all these risks line up at the same time and are we going to be okay?
Can we weather that?
Do we have enough liquidity outside of the real estate to be able to weather that?
Yeah.
Yeah.
And you know, kind of some of the things you're also alluding to there is risk for anindividual property, right?
(18:35):
And I think the common example of idiosyncratic risk or risk specific to one thing, youcan diversify away.
It's kind of like the classic stories.
If you were a trader from Venice back in the 1500s, you can buy one boat.
to go and get your goods and bring it back.
(18:57):
And you have an expected profit, but there's a risk that that boat sinks.
Well, what you could do is if 10 people are doing the same thing, you can each invest one10th in something.
One boat might sink, but you still have nine boats.
And so as a whole, you're better off.
And that's one of the challenges when you think about direct investing is you can't aseffectively deploy diversification techniques.
(19:23):
that you can in other aspects of your portfolio.
So it builds up this potential that you could have a catastrophic loss or something verydamaging that's just not quite the same if you can diversify some of that stuff away.
There's there's no doubt and I think what we've seen it's for a lot of our clients thatare the most successful in real estate investing.
(19:45):
Rarely do we see it being very very successful with people that own one property or twoproperties.
Not necessarily because the risk but I agree with you that I think that is something thatis absolutely accurate it's just I think there's also an element of just getting better
and learning and when you have one property
Every time you fail, kind of like it really impacts your returns.
(20:07):
When you own 25 properties, you can spread some of your costs out over, know, over allthose properties.
You learn, you don't make the mistake, same mistakes twice.
And so it becomes more like a business than it does just an investment that you're tryingto manage.
Maybe we could talk a little bit about, think the last thing here, just from a riskstandpoint, we were alluding to this and I kind of made some examples of this, but just
(20:27):
the boom and bust nature that can happen in real estate.
And I think some of this is tied to leverage.
Whenever you use leverage, there's just, amplifies the good and the bad of an investment.
So if I'm buying something for 100 % debt or 95%, I'm taking out debt for it.
(20:49):
the chances that I could get underwater happen very quickly and that can start to escalateif that happens with a lot of people.
So leverage, you know, I think that the time that I'd say, or, you know, just I recall isthe '06 '07 then into '08 period.
And if people remember that, that was kind of the boom period in real estate.
(21:09):
The very beginning of that was kind of the boom period where, you would turn on the TV andevery, every, you know,
show was around renovating a house and flipping, know, flipping homes and things likethat.
And it felt like everybody was getting into that.
And, you know, it's always scary when you hear people that have no understanding orknowledge about an investment really going all in on that.
(21:31):
And so, you know, I've heard that with technology stocks in 2000, it felt the same way in05 with real estate.
You could make an argument that maybe crypto could have a similar feel right now.
So I do think that oftentimes, once something has a really good return for a long periodof time, or at least a significant period, some people pile into it and they may not have
(21:53):
the right, we're going to get into how we evaluate and analyze things.
I'm not sure everybody did that.
But again, that's just kind of the cyclical nature of it is that you can have lots ofpeople, a lot of capital flow into it.
And a lot of capital can leave.
The fact that it's highly leveraged as well, people can get underwater really quickly andthat just exacerbates kind of the trend.
Yeah.
And you know, directly related to real estate, when you look at the long run evidence ofreturns, barely outpaces inflation.
(22:23):
And what you've seen is a dramatic increase in price appreciation very recently, which,you know, now you're always asking the question, can I expect this to continue or is this
the abnormal time?
And how do I think about balancing
those trade-offs and the fact that we probably really, really don't know.
(22:47):
So how do you balance that going forwards?
It's also, you know, one of the challenging things is when you think about an investment,you really focus on that particular investment.
And what we're trying to also do is say, we're actually a choice, right?
You can choose this investment or you can choose a different investment.
(23:09):
And you alluded to this at the very beginning of conversation where you want kind of stockmarket like returns, if not greater.
So the other thing we're thinking about is opportunity cost, opportunity cost in terms ofdollars, opportunity cost in terms of time.
And I think that's a really helpful analysis just to say, hey, you could do this.
What else could you do?
(23:32):
And then use that to, um, to inform your decision and your hurdle rates for whichinvestment.
you select.
It's a really good point.
This one is where I see the biggest issues I see with opportunity costs is less so in thepurchase of real estate and more so in the analysis of whether should I keep this real
(23:53):
estate property or not.
To your point, prices have gone up so much over the last 10, 15, 20 years.
And so if rent hasn't gone up commensurately, what that means is that most of your futurereturns
may not be as good because you're gonna need, we'll get into some of the numbers, but theincome you're generating from the property as a percentage of the value of the property is
(24:16):
actually going down because the property value is going up and maybe rent is not going upas quickly.
So when you're doing this analysis a lot of times, maybe when you purchase the property,it was a pretty good investment.
You did the math and you said, I'm gonna earn a decent return here.
you know, you may have gotten really lucky and the appreciation has gone up significantlyover the past, let's say 10 years.
(24:39):
You should probably go back and do that analysis and say, should I expect the same returnfor the next 10 years that I did the last 10 because a lot of my return has not come from
income, it's come from appreciation.
Will that continue knowing what the data says, knowing what the history says, you know, ata minimum, even if you do expect the same price appreciation, your income return
(25:02):
should be lower most likely because the rent hasn't gone up commensurately if that's trulythe case.
I think the opportunity cost is not only at the purchase, but I believe people should bethinking about it each and every year when they're evaluating what's the expected return
on this property now given that the things have changed potentially.
Yes.
(25:22):
Yeah.
And thinking about the real right way to do this, which is incredibly challenging becausealmost nobody has this data in a format that's easily to do is what's called a public
market equivalent analysis, where you say, I'm going to match my cash inflows and outflowsto a decision of buy, sell a public equivalent.
(25:43):
Right?
So you say, Hey, I have to put some money into the property.
Well, that was actually a choice in that time that you could have done somethingdifferent.
Again, these analysis incredibly challenging, but what you tend to find is the, uh, thereturn to me, what you think you get and what you got narrows down dramatically when
you're able to actually get that analysis.
(26:04):
And the best place we could kind of see some of that stuff is with private, privateinvestments.
but all this comes to.
the actual analysis part, right?
And it's really, really important to think about realistic expectations.
So maybe just talk with us around realistic income expectations and how you think aboutputting those together.
(26:27):
One of the benefits we have at Greenspring is we have so many clients that are real estatedevelopers.
And so we've been able to spend lots and lots of time with them over the years,understanding how they look at really big projects that they're getting into could be
apartment complexes or shopping malls or retail centers or things like that.
(26:47):
And I think one of the things that we've learned over time, and you can take that kind ofinstitutional
experience and bring it down to how you would evaluate just a single property that youmight think about buying.
And I think one of the things that we've learned over time is that the underwriting,meaning how you model your investment is so important.
(27:11):
If you look at some of the best investors in the world, far as how they invest developers,how they do this, is every single
factor and assumption that goes into it, they want to be conservative with it.
They want to assume that things aren't going to be perfect in every single way becausethey know they've been in the business a long time.
They know how things can go wrong.
So whether it be your occupancy rate or your repair costs or a lot of times, depending onhow you finance the property, you might not get fixed rate debt.
(27:41):
You might have variable debt.
So what your interest rates are going to be over time.
All these different things are factors.
We're going to go through each, you know, some of these factors when you're thinking aboutbuilding a model to try to figure out what the returns may look like.
But I would say that number one is be conservative with your assumptions, be conservativein your underwriting and building this out because, you know, most likely there's going to
(28:05):
be things that go wrong that you can't expect and there'll probably be some things that gowell.
But be conservative so that if you can outperform, just returns will be a little bitbetter.
If you can make the model work with conservative assumptions, then you're going to feel alittle bit better about buying the property.
Yeah, Warren Buffett, if you listen to some of the stuff he says, he's like, I neverreally do an in-depth discounted cashflow analysis.
(28:32):
That's not what I do because it has to make so much sense before I even run the numbers.
Because if you're trying to make the numbers work, that's the real challenge of the game.
And it's realistic.
inputs, that's something you have to really be thoughtful about.
And then it's also, hey, when you get the number at the end of the day, what's thelikelihood that you can get this number?
(28:57):
And is that number a big enough hurdle over what you could get with less effort tocompensate you for the direct invest you're taking?
So yeah, you mentioned on the input side, occupancy.
rates, right?
Which is, if it's just a single family home, you really have to think about how often areyou redoing your leases, right?
(29:24):
If it's every year, there's probably at least a month in between there where somebody'smoving and somebody's coming out and you got to do a little bit of repair work.
And so that's like almost the most aggressive you could be in that standpoint.
And that's not even assuming.
Hey, what if it lingers on the market and I have to adjust my price?
Probably one of the most the biggest errors I see is people just say what here's what therent is it's you know $2,000 a month and that's what they use in their assumptions and to
(29:54):
your point there will be I don't know when maybe not for a year maybe not for two yearsbut there'll be some period where either A) your renter moves out you need to move
somebody in and even if you have a renter to ready to go you may they may move out but youmight realize gosh I have to make some repairs to the property that
carpets terrible, we need new paint, whatever it is.
And it might mean that for a few months, you need to have some repairs done, can't have arenter in there.
(30:17):
So you should be using some percentage of the expected rent as your occupancy rate.
typically I tend to see somewhere in the 90 % range to be conservative again, in yourunderwriting.
Moving up, there's a general rule of thumb when you talk to residential real estateinvestors that they tend to take when they're looking at a very quick, like a Warren
(30:42):
Buffett back of the envelope.
Let me just take a quick look to see if this works.
And it's the 1 % rule, which is you take 1 % of the value of the property.
That should be your monthly rent.
So if I'm buying a $500,000 property as a general rule of thumb,
I should be getting about $5,000 a month, 1 % of that, in rent.
(31:04):
And so that's just right off the bat.
If you don't see that, would say there's probably, it's going to be a little bit morechallenging to kind of have a decent return with this property unless there's something
else going on that you can kind of point to that might increase your returns.
Yeah, yeah, this is a, it's a great example of a rule of thumb being incredibly helpful.
(31:27):
And then very interesting when you see that rule of thumb start to break down and peoplestart saying, well, it doesn't work in these markets, right?
Hey, it doesn't work in San Francisco.
You got to use a number closer to half that because values have increased so much relativeto the rent you can extract.
the implicit argument there is.
(31:50):
Values will keep increasing so much relative to the rent you can extract, which switchesyou maybe from a, think you're buying income, but what are you really buying?
You're buying expected price appreciation, expected price appreciation disfactored fromfundamentals.
(32:11):
Another word for that might be speculation.
Yeah, totally agree with that.
think that's obviously the way people think about buying properties that the incomedoesn't work.
The only other area you're going to make money on is appreciation then.
that is, to your point, speculative.
It is much more difficult to predict what price appreciation is going to do in a region orto a specific property compared to
(32:37):
It's a lot easier to predict what my income is going to be from that property.
have a lease.
I can look at it for the next 12 months, as long as that person doesn't break their lease.
know what I'm going to be receiving.
There's a decent chance that there's a market there that I can, if they leave, I can findsomebody else that's going to pay somewhere right around there.
Appreciation is all over the board.
You have no idea.
There's so many things that could impact that.
(32:58):
Yeah.
Yeah.
And if, if I just go back to the income thing, one of the things we were chatting aboutbefore, is, um, income, the more certain you can be about that, right?
We were kind of talking about some federal housing programs and why people might want tobuy houses targeted to rent out near those.
Cause you have a little bit more certainty.
(33:20):
Hey, here's going to be the income for this area.
So you have more confidence in the numbers working out.
You have more confidence.
in the fact that you'll get that.
You might have a different trade off and, hey, are you sure you could do the rightdiligence to get the right tenant in there?
But that's something that we do see across our clients is trying to think about lowerproperty values, higher rents.
(33:42):
How do you work on those two factors to get closer to that 1 %?
And those are the situations that if your goal is income, tend to be, we see working outon paper.
a little bit better.
Yep.
So I think the second factor, kind of the second thing to think about, so we have incomewe've talked about, but I think the next thing is all the costs that go into managing a
(34:07):
property and how do you underwrite those?
How do you figure out what you should be using for costs?
So I'm going to start with a rule of thumb and then maybe we can get into, I think thisone's a little bit more challenging on rules of thumb, but I do think it's just somewhere
again, if you're trying to look at a,
listing somewhere and do an analysis to say what's realistic cost?
(34:28):
I would say most of the time what I've seen is that cost expectations are somewhere around50 % of the rent.
So I'll go back to my example of a half a million dollar property.
If I have $5,000 in rental income, I should expect or I could expect to see costssomewhere in the $2,500 a month range.
(34:50):
And again,
That probably scales up and down a little bit based on size of property and other HOAs andother different fees like that.
anyways, that's just a basic rule of thumb.
So this is going to be things like property management, real estate taxes, insurance,repairs, maintenance, all those types of things that come up.
(35:11):
it's a little bit more lumpy than rent because some of those things you just don't havemaybe in a given year, you don't have repairs, you don't have maintenance.
but all the sudden you can have them in big chunks sometimes.
And that's kind of the other thing to kind of think through.
A lot of times this part of it, the cost side of it, I found clients, they might thinkabout some of the basic explicit costs like, what are my taxes?
(35:32):
What are my insurance?
Repairs and maintenance is one that I see people disregard or really underweight.
And it might be because for a couple of years they don't have any.
And it's like, it feels like there's not a whole lot of downside.
And then all of a sudden there's one big repair and you realize, wow, if I do the math,that just really degraded my return over the past three years when I do the math over the,
(35:57):
you know, and average it out.
Yeah, in kind of extrapolating that, we talk about investors with multiple properties,cashflow from multiple properties.
If one bad thing happens, you tend to have a little bit more income in cashflow.
You can spread your reserves around a little bit more strategically, which creates less ofa, hey, all of sudden I have this house and it's kicking me off income, but now I have to
(36:24):
put a lot more money back into it.
Did I think about the structure of that arrangement correctly?
So I think that kind of, there's so many downstream implications, right?
It's not just, hey, here's what the rent is and here's how much my mortgage is, anythingbetween the difference plus what I pay off in equity is an expected gain.
There's a lot of small things you have to think through.
(36:47):
And then that kind of gets to, you think about income, you think about cost.
and then you kind of end up with a few different numbers that you can use to evaluate, howprofitable is this?
And then from those profitability metrics, then you can kind of think about, well, howdoes that equate to return?
So maybe just share some insight on some different profitability metrics that you get toafter you think about income and costs.
(37:13):
Probably the most important one that we kind of measure for our clients regularly is caprate.
So this is the net operating income of the business or of the property divided by thevalue of the property.
So it's pretty simple.
You're basically just saying, what's my rent?
What are the costs associated with it?
And when I say the costs, costs outside of debt.
So the way you can think about cap rate is if I were to...
(37:36):
If I'm going go back to my $500,000 property, if I were to buy, if I had a $500,000 checkand I went and bought this property, what kind of net income am I going to get on that
$500,000?
What's my, after all my costs and expenses, well, how much do get to take home?
So it's an important number because it's kind of, it's something that you can use toevaluate against other types of investments.
(37:58):
You know, if I were to invest in a treasury bill and I put $500,000 in a treasury bill,
What's my yield?
What am I going to get in a return?
so cap rate is something again that you want to look at and that could be used as acomparison against other investments basically to say what other kind of returns would I
be getting in other investments compared to this?
So cap rate wise, would say, we love to see cap rates in the 10 % range because then youstart, you're basically approaching equities.
(38:27):
I would say we rarely see that these days.
so, you know, realistically cap rates more in the 5 % range, maybe a little higher wouldbe a good place to be.
I will say there's many times we do analysis and we see cap rates at 2%, 1%.
And, um, it's a really, I mean, again, to your point before, when you see that you areessentially.
(38:50):
It's just focusing on price appreciation.
That's what you're saying is I'm not going to make any money on, on, on the rent.
So I'm hoping kind of it's a hope strategy.
I'm hoping that the value of this property goes up significantly over time.
So I think that's probably an important factor to think of.
(39:11):
Realize too, if you have a cap rate at 1 or 2 % and you are using debt to finance thisproperty, you are gonna be cashflow negative because the cost of finance right now is
maybe 7%.
and you are only earning 1 % or 2 % in yield on the property.
So you're gonna be losing money.
(39:32):
Now you might say that's okay because I think I'm making it up in appreciation, but everyyear you're gonna have money going out the door basically between all of your costs and
your debt financing.
So I think that's an important factor when you look at that is you should probably do ananalysis to say, how much does this property need to appreciate?
(39:53):
for me to actually start making money on it and how much does it need to appreciate notonly to start making money but to also actually have a decent return compared to what I
might be able to invest in in other areas.
Yeah.
And this is a situation where leverage tends to help leverage also gives you insight intoyour hurdle rate, right?
(40:13):
Like your expect return kind of has to be above your cost of financing.
Otherwise the math is not going to, not going to work out.
that helps you do a bunch of different things.
How long is it going to take me to break even on my investment?
It's a classic one, right?
[How am I] held in here.
The other one I think gets a lot of focus is building equity in the property over time assomething that people, including myself, we, hey, don't discount the fact that every month
(40:46):
I get $700 more equity.
So that's another way people are viewing these different analysis.
totally agree.
think that's got to go into your analysis of, yes, you might be underwater cash flow wise,but you can almost look at it to some degree as an investment that you're just putting
against the equity.
So you'll eventually hopefully get it back.
(41:07):
based on typical loans, the amortization, you won't see a whole lot of building of equityin the beginning because most of your mortgage payment is going towards.
interest in the beginning and it starts to, you know, it starts to increase as far as howmuch is going towards principal down the road.
So if you're going to use that approach of looking at equity, obviously you're going towant to have an amortization schedule to look to see how much am I building in equity over
(41:31):
time and factor that into your breakeven as well.
So when we're doing our analysis, that's typically what we're looking at is not just theincome, but also the equity because it's, you have to look at both.
few other things that I wanted to touch on here because they're just unique and we talkedabout them earlier in the podcast, but I do think it's important to talk through, which is
(41:51):
some of the tax advantages of real estate that might be a little bit different than whatyou would get if you were, again, using my example of comparing it to and just investing
in a treasury bill or investing it in stocks.
And so the three big ones on the tax side are first, depreciation.
When I buy a property as an investment, I'm able to depreciate the property over itsuseful life.
(42:14):
that for real estate, that tends to be about 30 years.
So I can take about 1 30th of the value of the property each year and deduct it againstany income that I have on that property.
So where that's really advantageous is if I'm earning income on my property and I normallywould have to pay tax on that income, I can shield it
(42:36):
by using some of this depreciation because depreciation is a tax item, but it's not a cashitem.
I don't have to actually pay anything for it.
I just get it as something I can depreciate.
So I think that's an important factor when you're looking at income.
A lot of times income with real estate tends to be, I don't wanna say it's tax free, butyou don't have to pay tax on it.
(42:56):
Let's just say today.
Now what's happening behind the scenes when you use depreciation?
Well, if I have a property that I bought for $300,000,
And every year I can depreciate, let's say $10,000 of that and use it against my income.
After five years, I'll have depreciated $50,000.
My basis in the property, what I paid for it is now not 300 anymore.
(43:20):
It's actually 250.
So I'm just reducing the basis of my product.
Why does that matter?
It matters when I go to sell it.
I have to recap recapture that basis.
So I think that's an important.
factor is that I'm getting some tax benefits now, but I'll have to pay for it later when Isell.
So that's number one, I think, in the tax side of things.
(43:42):
So you can kind of accelerate a lot of tax benefits, even though maybe you'll have to payfor them later.
So there's a value, there's a time value of money in that.
Let's just say, part two to that is that I have a property that maybe has been fullydepreciated, I've owned it for 30 years.
And I get to the point where I say, well, I really
don't really want to own this property anymore.
I'd love to upgrade to a better property.
(44:04):
I'd love to own a bigger property that has more rental income, but I'm going to have tosell my property, pay all this tax because I have no basis in the property.
So now maybe I have to pay, you know, a hundred thousand dollars of taxes to be able totake the proceeds and go buy another property.
Real estate offers kind of a unique opportunity called a 1031 exchange where you canexchange one property for another like kind property.
(44:29):
And by doing that, I don't have to pay the tax.
So I can kind of upgrade my property, if you will.
Now it doesn't mean that I get new basis in the property.
I have to take my old basis, which in my example was zero and transfer it to the newproperty.
But it does allow me to, you know, if I want to sell Apple because I think it's a great,you it's not, it's had its run.
(44:50):
and I want to buy Johnson and Johnson.
Well, there's a tax impact that I have to take to that if I'm buying and selling stocks.
With real estate, I can do it tax free as long as I follow some guidelines.
Maybe if we have enough interest over time, we'll have a whole podcast on 1031 exchangesbecause it's actually a very interesting topic.
just know that it is opportunity available that you don't have with other investments.
(45:12):
That's the exact phrase I expect to come out of the son of a CPA is we can have a wholepodcast on 1031 exchange.
If they're interesting.
Yeah.
There's one other on the tax side, just before we move on.
One other thing I wanted to mention, and we see, we have clients in both these camps, butthe IRS has a very important distinction on how you invest in a property and how you're
(45:37):
classified.
Are you an investor or are you a dealer?
And so I think it's important to understand the differences there and then what that couldmean from a tax perspective.
So are you a dealer?
That basically means, is this your profession to a large degree?
Are you using real estate as like your inventory because you are maybe, maybe I buy 150acres and it's commercially and I'm gonna parcel it off and sell it off and this is my
(46:08):
investment, but I'm actively soliciting, I'm actively marketing it, I'm actually activelyimproving, developing the property.
You can make the same.
argument potentially if I'm buying real estate and fixing it up and that's my business,that's what I'm doing, the IRS will likely view you as a dealer.
The benefit of that and so, well actually let me give it, the second option would be areyou an investor?
(46:33):
So this is more of like, are you more of a passive investor in real estate?
I'm just buying real estate.
I'm hoping for it to go up in price.
I'm collecting rent.
All the things that we've been talking about.
Most of things we've been talking about are investors.
So what's the difference?
The difference is if you are a dealer, the income and expenses are considered actuallyordinary kind of regular income items for you.
(46:55):
So if you have losses, which happens a lot in real estate because of depreciation, you canactually use your losses against your income.
That's an important distinction.
If you have losses and you're an investor, you cannot take your losses and offset otherincome with that.
You're considered passive.
They don't let you do that.
Now, also when you buy and sell, you're getting capital gains as an investor.
(47:16):
When you're a dealer, it's more income.
So there are important distinctions and there's all sorts of people that try to challengethe IRS on this based on what will favor them.
But I think it's important when you're thinking about doing the underwriting on theproperty, you also want to think about taxes and you want to look at your after-tax
return.
And important distinction will be, are you an investor or a dealer?
(47:38):
Yeah, this is the, this is what nobody tells you when you think about getting intofinances.
You think it's all about being a great business person and then you learn, Hey, this isreally about accounting and legal.
And those things oftentimes are not quite as much fun as reading a book about a, abusiness person.
(47:59):
should we jump into an example?
Is there anything else you want to say?
be a great time to kind of take all the stuff we've been talking about and maybe try toapply it to an actual kind of real life example.
Yeah.
And probably the person we should use as a guinea pig most is me.
I just went through it.
And I went through it with some of these unique attributes, right?
I think anytime you evaluate from the, investment you should do so at the very beginningfrom a clean slate.
(48:26):
the first thing you want to do is say, Hey, if I was going, I have to pretend as if I'mgoing to buy this house.
Even if I already own it.
because what you're really doing is you're making another decision to keep owning it.
And this is the thing about investments.
You kind of have to make these choices all the time, right?
I'm going to decide to continue to pursue this strategy, or I'm going to decide to dosomething different, but still doing something.
(48:54):
Oftentimes, if you do it right, is an active decision.
Another approach is just ignore things.
Don't recommend that one.
But so the first thing you want to do is say, hey,
I'm going to look at this from a clean slate objectively.
The second thing is something I mentioned at the very beginning, which is, is thereanything unique about me?
(49:14):
And this is the hardest part about investing is the humility to say I'm not that unique,right?
So I have this property, something that's unique about it is I have a really low mortgagerate.
That was a unique thing that not everybody else has.
And that was probably my one unique attribute.
(49:37):
You might make an argument that I had a townhome in a decently competitive place inWinston-Salem.
So this is a small college town.
A lot of people are moving there from the North, pretty sought after, tends to be biddingwars.
Downside, there was bidding wars everywhere in 2021.
So I'm not really sure I can view that as, is that unique?
(49:59):
So then you go into an analysis where you kind of think about exactly what you talk about.
Let me look at my purchase price.
One of the things that you mentioned, Pat, was a lot of the metrics we use are relevant tothe value of the property.
In real estate, value is not reflected every day like it is in stock markets, right?
(50:23):
So here's where I tend to see
And I caught myself doing this, being a little picky about what number am I going to use?
Am I going to use the price I paid?
Or am I going to use the expected value of the property today?
It matters from some of these metrics.
And this is where you can see the challenge of, well, it's this, I don't know.
And you kind of cherry pick and jump, jump between the two.
(50:45):
So you think about, here's the price I pay.
Do I have to incur any costs to get it ready?
for market.
Long story short, we decided to not rent it out.
We sold it mostly because I needed the down payment to buy another house as a primaryfactor.
But when I bought my new house, the sellers definitely had some work that they had to doof a pretty significant dollar amount to get the house ready for us to buy.
(51:13):
So there oftentimes is work that you put off and you don't quite recognize.
So we're going through, you have the prices that you're paying, you have the financingdecisions.
Again, this is kind of an asset, so we think.
And then here comes a lot of these different assumptions that have to be made.
(51:33):
And this is where, again, you want to be really, really conservative, right?
So what's the true rent that I can get?
And this is again, a spot where...
there's a ton of information out there in the marketplace.
You could go to Zillow and say, I'm looking for rental properties.
Here's.
Let me look at some options and see what people are listing them for.
(51:54):
So go in, find what we think is a reasonable comparison.
Challenge of already owning a home is I probably thought it was a little better than maybeit would be to the next person, right?
Like I love that house.
Vacancy is a really tough one.
think you can, again, we kind of reference that.
And then all the costs, right?
(52:14):
And I think one of the big...
there's kind of two hidden costs.
The first is...
the repair costs that you mentioned, what happens if something goes wrong?
How do you think about building some reserves to pay for that?
The second is we didn't live in the state, so we only have one option, which is propertymanagement.
But it tends to be about 10%.
(52:34):
That's a pretty significant cost that you're going to have to pay in exchange for nottaking on headaches.
That 10 % is going to matter a lot in
your ability to make money on the property relative to the opportunity cost.
you think about all these costs and then this allows you to do some of those metrics thatwe were talking about, right?
(53:03):
So what's my net operating income?
It's positive.
It looks like a great number.
I think this is one of the big traps is you're looking at, hey, what's my mortgage?
What do I pay versus what do I get in rent?
And that's where you tend to see some pretty big, nice numbers that look great.
(53:23):
When you zoom in and you think about some of those costs, the cashflow doesn't look quiteas great.
Even using leverage to cash on cash return, not as great.
Cap rates were around 3%.
So you kind of mentioned like, hey, this is what we're seeing with the low mortgage rate.
You're still kind of targeting a 3 % mortgage rate.
(53:45):
The 1 % rule, we were at half of that, which kind of just tells you price appreciation.
And so if you can't make the numbers work on a spreadsheet, that probably tells you a lotabout you're trying to force an investment.
And when you listen to all the greatest investors out there, they say things like, turneddown 90 % of the things that we look at.
(54:12):
Why?
Because it is so hard to find something that the market hasn't already priced in.
And again, you go back to, what was the theory?
What did I expect?
Have I expected this outcome?
Opportunity costs?
Could I have put the money to better use?
Yes, I could, because my family would like a place to sleep.
(54:34):
So just one example, again,
About 10%, over a hundred clients of Greenspring have direct invest private real estate.
The numbers, you want to be very thoughtful and work hard to think about those.
And then you want to think about what are those other extracurriculars?
(54:55):
Cause at the end of the day, money's not just dollars, right?
Is it an investment or am I going to get some alternate use out of it?
Am I going to be able to allow my kid a place to stay?
Am I going to be able to vacation there?
when I'm not renting it out.
These types of things are gonna come into play after you look at the numbers.
Yeah, it's a great, thank you for sharing the kind of your specific circumstances.
(55:18):
And it sounds like you came to the conclusion that the returns were not commensurateenough with kind of the risk that you were gonna have to take along with, you know, other
competing sources of capital that are competing investments for your capital.
I think it's the conclusion that you got to, you know, we talk about how many of ourclients invest in real estate.
Well,
There's another element to it, which is there's a lot that don't, you know, if, about 10 %do, then that means 90 % have not, decided to.
(55:44):
And I think that's an important, number to think about too.
It's not that there is a right or wrong answer with this, but you do also have to kind ofknow yourself to a degree.
And owning real estate is not a passive investment.
I mean, I think people have heard that before it's, it really isn't, you have to bewilling, even if you have a property manager to deal with properties.
I have a family member that owns an investment property that is managed by a propertymember.
(56:09):
And I can tell you it is the least thing from passive that you can think of becausethey're getting calls all the time about repairs that may be made to the property.
Now they may not have to do them all, but the part of the brain that has to kind of justdeal with the decision-making all the time of what do we do?
Should we make this repair?
Oh gosh, this person's not paying rent.
(56:30):
What do we do?
Do we have to evict them?
There are just these decisions that have to be made that a lot of times people don't wantto make them.
Or they look at the returns and say, it's not worth it for me to have to deal with this.
again, there's not a right or wrong answer.
I think you had some really good insight in that if you are going to decide to investdirectly in real estate yourself, you should think about what's kind of my competitive
(56:53):
edge here.
What do I have that can make this a really good investment?
could be
Maybe you're in a great area that you know really well and has great numbers when you dothe underwriting.
It could be a low mortgage.
It could be, you you already own this property and there's some advantages to it.
You know, there's a lot of different things, but if you don't know and you're just like, Ithought I'm just thinking of, you know, buy a property to rent it out and, you know, one,
(57:15):
do the underwriting.
If the numbers don't make sense, there's a really high likelihood that it's not going towork out very well.
So.
you know, just make sure you're mindful about investing before you jump into it.
That's right.
And, you know, one of the examples you gave is we work with a lot of real estatedevelopers.
We work with a lot of smart people in private equity.
(57:36):
And when you see their returns on Excel, they know it's really hard to get those on a onedeal thing.
First year is pretty easy to model out.
After that, there becomes a lot more uncertainty.
Right?
So this is one of the reasons why you think about
their expected return number, it's bigger than the realized return they're actuallyexpecting to get.
(58:02):
It doesn't typically work the other way.
And this gets into the nuances of returns with skewness and volatility.
But it is very helpful to have a significant dose of skepticism around, what's the truerisk equivalent?
(58:24):
to my investment and if I'm using leverage, comparing it to something with maybe lessleverage, I think that's an important consideration.
So what's the true risk equivalent?
And then how do I factor in challenges unique to me?
Like, am I taking on illiquidity?
I should, as an investor, I should want higher return in exchange for less ability toaccess that, unless it's such a small portion of my net worth that.
(58:50):
I disregard, which tends to the opposite for people if you go back into why do people getso attracted to real estate?
It's because the use of leverage can really amplify your ability to grow your net worth ifeverything triggers exactly right.
Absolutely, yeah.
I think it's a good place for us to end and maybe we'll have a geeky conversation abouttax free exchanges at some point in the future if people have an interest in that, but it
(59:19):
was a fun exercise going through.
I think it's a question that a lot of clients have.
And if you're a client of Greenspring, would say,
and you haven't gone through the analysis with your advisor, I would encourage you to havethese conversations because we do this every day.
And if you're not a client, you want somebody to take a second look, we're happy to help.
Yep, absolutely.
(59:39):
All right, thanks Pat.
Thank you.
Pat, great to see you again.
Lovely morning.
Great to see you too, good to be here.
As a quick reminder, everyone, I am Mark Schaefer, Greenspring's Director of Growth.
This is Pat Collins, our CEO.
And we are back to pick up on a conversation we had last time.
The conversation we had last time is looking at real estate.
Is your house an asset?
(00:27):
Is it a liability?
Is your house consumption or is it investment?
And when we think back to that conversation, I think one of the big surprising things thatcame out of it
was the really low return expectations for real estate after inflation.
The research shows it's about 1 % after inflation for price appreciation for real estate,which I think begs the question, is real estate a good investment when it's outside of
(00:57):
your house?
So things like rental real estate, and we thought it'd be really, really helpful for us todive into that question and how we look at it.
at Greenspring.
About 10 % of our clients do have this as an individual investment they're invested in.
So it's really common when you think about the type of people that we work with.
(01:18):
And we just thought it'd be helpful to look through it.
Yeah, I'm excited to dive into this topic.
It's, as you mentioned, we have well over 100 clients that invest in rental real estateand other types of real estate properties.
So it's a question we get all the time and we've done a lot of analysis, a lot of thinkingthrough this.
We're excited to share kind of our, hopefully our best thinking on this topic and givepeople some insights if you're thinking about.
(01:44):
either converting maybe a property you own as a personal residence to an investmentproperty or buying a property outright and renting it out.
So, excited to get into this.
Yeah, let's jump into it.
So I kind of led with 1 % real returns, which again means returns after inflation.
And then when you compare that number to what you see in kind of the public marketequivalent, the PME, so these are publicly traded REITs, real estate investment trusts,
(02:14):
and we tend to see after inflation returns of about 5 or 6%.
So significantly more than just the price appreciation.
Where's a lot of that difference coming from?
A lot of that difference is coming from the fact that you're receiving income.
Real estate investment trusts have to distribute 90 % of their income.
So it's kind of the rents, if you will, that are being kicked off.
(02:36):
And I think that's one of the really attractive things why people evaluate correctly heldreal estate is this idea of kind of passive income being kicked off.
from the portfolio.
And then building off that, what may be return expectations?
I guess this question for you, Pat, would you expect, or do you think investors expect fortargeting directly held real estate?
(02:57):
That's a great question.
I don't know.
think in working with clients over the last 20 plus years, I'm not sure if a lot ofclients think through that question, which is a really important one.
I think if you were to ask them, or at least if you were to ask me what your expectationswould be, I would think with an illiquid asset that has highly concentrated risk, I'd want
(03:18):
to have returns higher.
than equities, personally, publicly traded liquid investments expected returns I'd want tohave.
But in fact, I think almost every analysis we do on residential rental real estate, wetend to see expected returns to be a bit lower.
Now, the other side of that is that I think real estate probably as a general rule, has alittle bit more stability and price kind of movement.
(03:44):
You typically don't see every five years, 20 or 30 % pullbacks in real estate where youcould see that in stocks pretty regularly.
But it has happened and the illiquid nature of it, I think is something to consider.
But I do think when we kind of dig into it, what we're looking at is typically expectedreturns in the five to 8 % range would be a good.
(04:09):
solid return on residential real estate.
Yeah, yeah.
You bring up great points around certain risks.
Anytime you go concentrated, I view that as a bad signal for higher risk.
Well, let's maybe, we're going to dive into those numbers, how we think about buildingassumptions, how we think about assumptions on the inputs, assumptions on the outputs.
(04:34):
Maybe let's start with why people invest directly.
probably held real estate.
And what I mean by this is certain aspects that are unique to individuals that maybe thismakes a little bit more sense.
And one of the things, I guess it's a question I always ask myself when I'm thinking aboutinvesting is, do I have any specific skills or attributes that nobody else has that I am
(05:01):
bringing to the table?
Am I just bringing my capital or am I bringing something unique?
And I think this is one of the reasons why
we see many individuals kind of first dip their toes into this because they might bebringing something unique to the table that nobody else has.
So maybe just talk about some of the reasons why you see people getting into this.
(05:23):
First and foremost, I think a lot of times people get into it because it's something theyfeel like they know, they can touch, they can feel it, they can see it.
It doesn't feel like stocks due to many that haven't invested before.
Stocks might feel a little bit more like gambling or really risky.
And in their mind, gosh, how much can I lose in real estate?
Cause I own this property, I can go look at it or go walk into it every single day.
(05:46):
So I think.
That might be the beginning point part for a lot of people.
But there are some attributes of real estate that are just different than investing in aportfolio of stocks and bonds that are worth thinking through.
So the first is that real estate allows for leverage in a way that's just so differentthan stocks and bonds.
(06:07):
Yes, you can use leverage to buy stocks and bonds.
but not to the extent of real estate.
In many cases, you can buy real estate for almost 100 % of the value by just basicallygetting a loan.
So nobody that I know of are gonna loan you 100 % of the value of a stock portfolio foryou to go buy a stock portfolio.
And on top of that, you have all sorts of things like margin calls and things like thatthat people get scared of with stocks.
(06:31):
So I think that's a big part of that is you can use other people's money to buy realestate.
And that's,
that can be attractive.
Now, it's been really attractive over the past several years because interest rates havebeen so low.
You might be able to buy a real estate property for 3 % or less.
Now, that's changed here recently where the lending rates are 6%, 7%.
(06:55):
Could even be higher depending on the type of property, if you're buying an investmentproperty versus a personal residence.
So I think that's, but I think that's a really important distinction is that you don'tneed much money
to buy real estate and compared to building a million dollar stock portfolio, you got towork a long time, you got to save a lot.
You could do that over the course of a few years if you have a good enough income becausebanks will lend to you basically.
(07:19):
Yeah, which we'll talk about later, the boom bust cycle of real estate.
If it's easier to get into, it's easier to get a bunch of leverage into, tends to be morespeculative in nature.
of the things you mentioned there is just the change in mortgage rates.
And that presents a lot of opportunities where you might have an existing property at areally low mortgage rate.
(07:42):
In a sense, that might be one of your greatest assets, right?
Because it's really tough to give up.
3 % mortgage rate in exchange for a 7 % mortgage rate.
And so you might look at that and say, Hey, does this lower cost of financing give me acompetitive advantage in the industry that other people don't have?
(08:02):
That could be one thing that a lot of people are looking at saying, Hey, I have this lowinterest rate and it's especially true right now, but I think it's kind of always one of
these, components, right?
Hey, I have really good credit.
Well, I can lend to somebody that doesn't have that credit credit, right?
I can lend to somebody that doesn't have that great credit.
So there's that kind of interest rate arbitrage in a sense that might be going on as oneof the reasons.
(08:26):
Yeah, for sure.
Absolutely.
And I think there's a few others that I would touch on.
One is there's some tax benefits investing in real estate that you don't get withinvesting in other types of investments.
And we're going to dive into all these different things a little bit later.
But I do think that's a big factor is the tax code really kind of encourages real estateinvestments.
(08:50):
You can see, you you,
You look at a lot of wealthy people and a lot of people have made their money in realestate.
And one of the key attributes there is when you look and see how much they pay in taxes,it's not that much because they are figuring out ways to shield their income from tax.
They're looking at ways to defer gains on properties.
There's a lot of different factors there.
(09:11):
So I think it's just another aspect of real estate that you're not getting with stocks orbonds.
Yep.
Yeah.
I think that's, that's a great point.
I'll just name a few other ones we, uh, we thought of when we were brainstorming.
One is you're also viewing real estate investing as an occupation, right?
And maybe hobby is appropriate.
(09:34):
Maybe landlord is appropriate, but you're thinking, Hey, I have excess time and awillingness to do things.
I might have handyman skills.
I might have just an interest in some excess capacity where
Hey, why not use my money and also use my time and my energy, right?
(09:54):
I'm willing to take on headaches that somebody else doesn't want to take on, which is whythey're renting.
So that could be one.
And then also I know of, you know, in today's marketplace where you've seen a ton of priceappreciation in real estate, it makes owning a home for the next generation much more
difficult.
So we've also seen a lot of, a lot of parents
(10:15):
thinking about holding on to houses and property in a way to make sure their kids have achance to live in kind of similar lifestyles to how the parents grew up.
Yeah, absolutely.
I think when we're thinking about real estate and I think as we talk through in thispodcast, there's probably two different ways people I've seen invest in real estate for
(10:39):
residential investment.
one is, or maybe on one extreme you have just a pure buy and hold.
I'm buying a property, I'm going to rent it out, I'm going to collect the rent from it andhopefully over time I'm going to get both rent and appreciation on this property.
But I don't really have an intention of selling it.
I really am buying this as an income producing investment.
(10:59):
And then on the other side, you have what I would call maybe more value add type investorsthat are gonna buy a property hopefully at a cheap price, fixed it up.
And that's kind of where your sweat equity kind of the time energy resources that they mayhave could go into it.
I'm gonna fix this property up and then I'm going to sell it.
And the amount I put in plus what I paid for it is going to be less than what I can sellit for.
(11:23):
and that appreciation is what I'm kind of after.
And then you probably have somebody in the middle who does, buys the property, fixes itup, then rents it out and plans to hold it.
So there's kind of variations of those, but I would say that's probably the two or threemost common ways we've seen people invest in real estate.
(11:43):
Obviously there's other things you can do, like a straight buy and hold for appreciation.
you see...
there's going to be development coming into one area and you say, I'm going to try to buysome properties ahead of that.
I rarely see that that's more speculative.
But that's also a possibility too.
Yeah.
That's great.
Let's talk.
So we talked unique advantages.
(12:05):
Let's talk some of the risks about investing in real estate.
you kind of, I think referenced one, which is real estate.
You invest in what you know.
That also to me, when I'm evaluating this, when you invest in what you know, you tend toincrease your concentration.
because what you know tends to be very geographically concentrated.
(12:26):
And there's been studies out there where people tend to buy more individual stocks closerto where they live.
They know it, right?
This kind of like a common thing you'll see and that's what you know.
Well, what that means is you're kind of piling on your concentration risk to very specificmarkets, right?
Kind of thing.
Hey, where do I live?
(12:47):
That's where my job is.
Well, let me just add some additional net worth concentration right there.
And I think that's one of the things you have to be really cautious of is are you addingtoo much geographic specific risk to your total portfolio by adding real estate.
Yeah, this one is sometimes hard to see when you're in the midst of it because it's kindof like the boom and bust nature of it.
(13:15):
But I think there's examples even today.
We live outside the DC area and with a lot of the job losses happening, you could havelots of people looking to move out of DC.
DC tends to be a transient type area.
People come in to work for the government.
But if all of a sudden there's large, large job losses, you can see people leaving.
you can see property prices really dropping because of supply and demand factors.
(13:38):
There's another story that comes to mind with this.
I have a client who invested in real estate in North Dakota.
And it would be an interesting place, given that you live on the East Coast to investthere.
years and years ago, they started this kind of boom around fracking.
And there was a lot of oil that was found there, and they figured out ways to get out ofthe ground.
(13:59):
created all sorts of opportunities for people having to move there to work on these kindof, you know, these rigs and whatnot.
And they needed places to stay, they needed places, you know, for restaurants, foroffices.
I mean, all sorts of different services and facilities had to come out there.
And so, you know, he kind of lived through a boom and bust period.
And it was really interesting to see.
(14:20):
It's just, it was so specific to the price of oil.
is what drove in a lot of real estate because when the prices got too low, they couldn'tmake the numbers work for drilling.
So all of a sudden people left.
And when the prices got higher, they all came back and they all needed rental places.
it's just a, you know, that's probably an extreme example of being kind of a boom bust,but I think anywhere you're investing, you do have to be careful of is there any factor
(14:48):
that could happen that would cause people to want to leave or?
Or the other way, could work in your favor.
But I do think those things are hard to see sometimes.
Most people don't think that there was going to be massive job cuts to the entire federalsector, but it happens.
Yeah, this is the, this is the thing about risk.
It's always there, but you never see it.
(15:09):
Right.
And the reason why we call them risk factors, because it's really tough beyond the factthat we know there's an amount of risk to understand what is the actual underlying risk.
And then how do I build something that hedges against that super, super tough to, uh, todo, but you also kind of alluded to another, I think.
(15:30):
Unique.
aspect about direct investment, real estate, and that's illiquidity, right?
Because you were talking about boom and bust.
Not really that big of an issue if you can sell like this, like you can in a mutual fundor an ETF or a single stock.
But when you think about individual housing, it tends to be much more, there's a timehorizon, how long it takes to sell.
(15:56):
There's just a lot more.
hurdles to getting your money out, putting your money back into play.
You think about transaction costs.
So I think that's also, that's something that I would think really, really long and hardabout is this money is not easy to access.
And sometimes that's a good thing for certain people, but oftentimes it's not a greatthing.
(16:16):
Yeah, I've had more instances of this illiquidity issue come up over the years than I careto admit with clients because it's hard to watch.
So a few things on this, obviously, you're making assumptions when you buy a property thatyou're going to have a renter in there.
(16:36):
That person is going to rent out the property for some set amount of income.
is not coming in because maybe you have a hard time leasing it out or there's massiverepairs that need to get done.
And that means that you can't have anybody in there while those repairs are getting done.
There's still costs associated with the property at that time.
you still have, if you have a debt, if you have mortgage, you still have your mortgagepayment.
(16:57):
You still have taxes, you still have insurance, you still have utilities that you have topay.
And so all these things
just add up and obviously depending on your personal financial situation, it could bereally, really detrimental from the standpoint of having negative outflows with no
liquidity.
And then, you know, on the other side of it, let's say you've had it for a long time andyou have a lot of equity in the house.
(17:21):
Well,
There's also risks around, well, could I pull that equity out if I need to at some pointin the future for liquidity?
A lot of times that's the kind of conversation that people have.
Well, yeah, I can't sell it, but I could always get a mortgage on the property.
I have a lot of equity in it.
That's true.
But you also have to think about your personal circumstances.
I've had situations where clients are looking to take out a mortgage on it, but because oftheir personal financial situation, maybe they're not working.
(17:48):
maybe they lost their job, it's an exact time when they need liquidity, and they go to tryto get a mortgage on the property and the bank says, sorry, I don't know how you're going
to pay this back, especially if the renter might leave.
So we're just not comfortable giving you a mortgage because you don't have any income.
And so these are all things that you have to think through is that it may not seem like abig deal now, but it's kind of like when that perfect storm hits, could that be a problem?
(18:12):
And obviously, when we're talking to clients, we want to think through
What if all these risks line up at the same time and are we going to be okay?
Can we weather that?
Do we have enough liquidity outside of the real estate to be able to weather that?
Yeah.
Yeah.
And you know, kind of some of the things you're also alluding to there is risk for anindividual property, right?
(18:35):
And I think the common example of idiosyncratic risk or risk specific to one thing, youcan diversify away.
It's kind of like the classic stories.
If you were a trader from Venice back in the 1500s, you can buy one boat.
to go and get your goods and bring it back.
(18:57):
And you have an expected profit, but there's a risk that that boat sinks.
Well, what you could do is if 10 people are doing the same thing, you can each invest one10th in something.
One boat might sink, but you still have nine boats.
And so as a whole, you're better off.
And that's one of the challenges when you think about direct investing is you can't aseffectively deploy diversification techniques.
(19:23):
that you can in other aspects of your portfolio.
So it builds up this potential that you could have a catastrophic loss or something verydamaging that's just not quite the same if you can diversify some of that stuff away.
There's there's no doubt and I think what we've seen it's for a lot of our clients thatare the most successful in real estate investing.
(19:45):
Rarely do we see it being very very successful with people that own one property or twoproperties.
Not necessarily because the risk but I agree with you that I think that is something thatis absolutely accurate it's just I think there's also an element of just getting better
and learning and when you have one property
Every time you fail, kind of like it really impacts your returns.
(20:07):
When you own 25 properties, you can spread some of your costs out over, know, over allthose properties.
You learn, you don't make the mistake, same mistakes twice.
And so it becomes more like a business than it does just an investment that you're tryingto manage.
Maybe we could talk a little bit about, think the last thing here, just from a riskstandpoint, we were alluding to this and I kind of made some examples of this, but just
(20:27):
the boom and bust nature that can happen in real estate.
And I think some of this is tied to leverage.
Whenever you use leverage, there's just, amplifies the good and the bad of an investment.
So if I'm buying something for 100 % debt or 95%, I'm taking out debt for it.
(20:49):
the chances that I could get underwater happen very quickly and that can start to escalateif that happens with a lot of people.
So leverage, you know, I think that the time that I'd say, or, you know, just I recall isthe '06 '07 then into '08 period.
And if people remember that, that was kind of the boom period in real estate.
(21:09):
The very beginning of that was kind of the boom period where, you would turn on the TV andevery, every, you know,
show was around renovating a house and flipping, know, flipping homes and things likethat.
And it felt like everybody was getting into that.
And, you know, it's always scary when you hear people that have no understanding orknowledge about an investment really going all in on that.
(21:31):
And so, you know, I've heard that with technology stocks in 2000, it felt the same way in05 with real estate.
You could make an argument that maybe crypto could have a similar feel right now.
So I do think that oftentimes, once something has a really good return for a long periodof time, or at least a significant period, some people pile into it and they may not have
(21:53):
the right, we're going to get into how we evaluate and analyze things.
I'm not sure everybody did that.
But again, that's just kind of the cyclical nature of it is that you can have lots ofpeople, a lot of capital flow into it.
And a lot of capital can leave.
The fact that it's highly leveraged as well, people can get underwater really quickly andthat just exacerbates kind of the trend.
Yeah.
And you know, directly related to real estate, when you look at the long run evidence ofreturns, barely outpaces inflation.
(22:23):
And what you've seen is a dramatic increase in price appreciation very recently, which,you know, now you're always asking the question, can I expect this to continue or is this
the abnormal time?
And how do I think about balancing
those trade-offs and the fact that we probably really, really don't know.
(22:47):
So how do you balance that going forwards?
It's also, you know, one of the challenging things is when you think about an investment,you really focus on that particular investment.
And what we're trying to also do is say, we're actually a choice, right?
You can choose this investment or you can choose a different investment.
(23:09):
And you alluded to this at the very beginning of conversation where you want kind of stockmarket like returns, if not greater.
So the other thing we're thinking about is opportunity cost, opportunity cost in terms ofdollars, opportunity cost in terms of time.
And I think that's a really helpful analysis just to say, hey, you could do this.
What else could you do?
(23:32):
And then use that to, um, to inform your decision and your hurdle rates for whichinvestment.
you select.
It's a really good point.
This one is where I see the biggest issues I see with opportunity costs is less so in thepurchase of real estate and more so in the analysis of whether should I keep this real
(23:53):
estate property or not.
To your point, prices have gone up so much over the last 10, 15, 20 years.
And so if rent hasn't gone up commensurately, what that means is that most of your futurereturns
may not be as good because you're gonna need, we'll get into some of the numbers, but theincome you're generating from the property as a percentage of the value of the property is
(24:16):
actually going down because the property value is going up and maybe rent is not going upas quickly.
So when you're doing this analysis a lot of times, maybe when you purchase the property,it was a pretty good investment.
You did the math and you said, I'm gonna earn a decent return here.
you know, you may have gotten really lucky and the appreciation has gone up significantlyover the past, let's say 10 years.
(24:39):
You should probably go back and do that analysis and say, should I expect the same returnfor the next 10 years that I did the last 10 because a lot of my return has not come from
income, it's come from appreciation.
Will that continue knowing what the data says, knowing what the history says, you know, ata minimum, even if you do expect the same price appreciation, your income return
(25:02):
should be lower most likely because the rent hasn't gone up commensurately if that's trulythe case.
I think the opportunity cost is not only at the purchase, but I believe people should bethinking about it each and every year when they're evaluating what's the expected return
on this property now given that the things have changed potentially.
Yes.
(25:22):
Yeah.
And thinking about the real right way to do this, which is incredibly challenging becausealmost nobody has this data in a format that's easily to do is what's called a public
market equivalent analysis, where you say, I'm going to match my cash inflows and outflowsto a decision of buy, sell a public equivalent.
(25:43):
Right?
So you say, Hey, I have to put some money into the property.
Well, that was actually a choice in that time that you could have done somethingdifferent.
Again, these analysis incredibly challenging, but what you tend to find is the, uh, thereturn to me, what you think you get and what you got narrows down dramatically when
you're able to actually get that analysis.
(26:04):
And the best place we could kind of see some of that stuff is with private, privateinvestments.
but all this comes to.
the actual analysis part, right?
And it's really, really important to think about realistic expectations.
So maybe just talk with us around realistic income expectations and how you think aboutputting those together.
(26:27):
One of the benefits we have at Greenspring is we have so many clients that are real estatedevelopers.
And so we've been able to spend lots and lots of time with them over the years,understanding how they look at really big projects that they're getting into could be
apartment complexes or shopping malls or retail centers or things like that.
(26:47):
And I think one of the things that we've learned over time, and you can take that kind ofinstitutional
experience and bring it down to how you would evaluate just a single property that youmight think about buying.
And I think one of the things that we've learned over time is that the underwriting,meaning how you model your investment is so important.
(27:11):
If you look at some of the best investors in the world, far as how they invest developers,how they do this, is every single
factor and assumption that goes into it, they want to be conservative with it.
They want to assume that things aren't going to be perfect in every single way becausethey know they've been in the business a long time.
They know how things can go wrong.
So whether it be your occupancy rate or your repair costs or a lot of times, depending onhow you finance the property, you might not get fixed rate debt.
(27:41):
You might have variable debt.
So what your interest rates are going to be over time.
All these different things are factors.
We're going to go through each, you know, some of these factors when you're thinking aboutbuilding a model to try to figure out what the returns may look like.
But I would say that number one is be conservative with your assumptions, be conservativein your underwriting and building this out because, you know, most likely there's going to
(28:05):
be things that go wrong that you can't expect and there'll probably be some things that gowell.
But be conservative so that if you can outperform, just returns will be a little bitbetter.
If you can make the model work with conservative assumptions, then you're going to feel alittle bit better about buying the property.
Yeah, Warren Buffett, if you listen to some of the stuff he says, he's like, I neverreally do an in-depth discounted cashflow analysis.
(28:32):
That's not what I do because it has to make so much sense before I even run the numbers.
Because if you're trying to make the numbers work, that's the real challenge of the game.
And it's realistic.
inputs, that's something you have to really be thoughtful about.
And then it's also, hey, when you get the number at the end of the day, what's thelikelihood that you can get this number?
(28:57):
And is that number a big enough hurdle over what you could get with less effort tocompensate you for the direct invest you're taking?
So yeah, you mentioned on the input side, occupancy.
rates, right?
Which is, if it's just a single family home, you really have to think about how often areyou redoing your leases, right?
(29:24):
If it's every year, there's probably at least a month in between there where somebody'smoving and somebody's coming out and you got to do a little bit of repair work.
And so that's like almost the most aggressive you could be in that standpoint.
And that's not even assuming.
Hey, what if it lingers on the market and I have to adjust my price?
Probably one of the most the biggest errors I see is people just say what here's what therent is it's you know $2,000 a month and that's what they use in their assumptions and to
(29:54):
your point there will be I don't know when maybe not for a year maybe not for two yearsbut there'll be some period where either A) your renter moves out you need to move
somebody in and even if you have a renter to ready to go you may they may move out but youmight realize gosh I have to make some repairs to the property that
carpets terrible, we need new paint, whatever it is.
And it might mean that for a few months, you need to have some repairs done, can't have arenter in there.
(30:17):
So you should be using some percentage of the expected rent as your occupancy rate.
typically I tend to see somewhere in the 90 % range to be conservative again, in yourunderwriting.
Moving up, there's a general rule of thumb when you talk to residential real estateinvestors that they tend to take when they're looking at a very quick, like a Warren
(30:42):
Buffett back of the envelope.
Let me just take a quick look to see if this works.
And it's the 1 % rule, which is you take 1 % of the value of the property.
That should be your monthly rent.
So if I'm buying a $500,000 property as a general rule of thumb,
I should be getting about $5,000 a month, 1 % of that, in rent.
(31:04):
And so that's just right off the bat.
If you don't see that, would say there's probably, it's going to be a little bit morechallenging to kind of have a decent return with this property unless there's something
else going on that you can kind of point to that might increase your returns.
Yeah, yeah, this is a, it's a great example of a rule of thumb being incredibly helpful.
(31:27):
And then very interesting when you see that rule of thumb start to break down and peoplestart saying, well, it doesn't work in these markets, right?
Hey, it doesn't work in San Francisco.
You got to use a number closer to half that because values have increased so much relativeto the rent you can extract.
the implicit argument there is.
(31:50):
Values will keep increasing so much relative to the rent you can extract, which switchesyou maybe from a, think you're buying income, but what are you really buying?
You're buying expected price appreciation, expected price appreciation disfactored fromfundamentals.
(32:11):
Another word for that might be speculation.
Yeah, totally agree with that.
think that's obviously the way people think about buying properties that the incomedoesn't work.
The only other area you're going to make money on is appreciation then.
that is, to your point, speculative.
It is much more difficult to predict what price appreciation is going to do in a region orto a specific property compared to
(32:37):
It's a lot easier to predict what my income is going to be from that property.
have a lease.
I can look at it for the next 12 months, as long as that person doesn't break their lease.
know what I'm going to be receiving.
There's a decent chance that there's a market there that I can, if they leave, I can findsomebody else that's going to pay somewhere right around there.
Appreciation is all over the board.
You have no idea.
There's so many things that could impact that.
(32:58):
Yeah.
Yeah.
And if, if I just go back to the income thing, one of the things we were chatting aboutbefore, is, um, income, the more certain you can be about that, right?
We were kind of talking about some federal housing programs and why people might want tobuy houses targeted to rent out near those.
Cause you have a little bit more certainty.
(33:20):
Hey, here's going to be the income for this area.
So you have more confidence in the numbers working out.
You have more confidence.
in the fact that you'll get that.
You might have a different trade off and, hey, are you sure you could do the rightdiligence to get the right tenant in there?
But that's something that we do see across our clients is trying to think about lowerproperty values, higher rents.
(33:42):
How do you work on those two factors to get closer to that 1 %?
And those are the situations that if your goal is income, tend to be, we see working outon paper.
a little bit better.
Yep.
So I think the second factor, kind of the second thing to think about, so we have incomewe've talked about, but I think the next thing is all the costs that go into managing a
(34:07):
property and how do you underwrite those?
How do you figure out what you should be using for costs?
So I'm going to start with a rule of thumb and then maybe we can get into, I think thisone's a little bit more challenging on rules of thumb, but I do think it's just somewhere
again, if you're trying to look at a,
listing somewhere and do an analysis to say what's realistic cost?
(34:28):
I would say most of the time what I've seen is that cost expectations are somewhere around50 % of the rent.
So I'll go back to my example of a half a million dollar property.
If I have $5,000 in rental income, I should expect or I could expect to see costssomewhere in the $2,500 a month range.
(34:50):
And again,
That probably scales up and down a little bit based on size of property and other HOAs andother different fees like that.
anyways, that's just a basic rule of thumb.
So this is going to be things like property management, real estate taxes, insurance,repairs, maintenance, all those types of things that come up.
(35:11):
it's a little bit more lumpy than rent because some of those things you just don't havemaybe in a given year, you don't have repairs, you don't have maintenance.
but all the sudden you can have them in big chunks sometimes.
And that's kind of the other thing to kind of think through.
A lot of times this part of it, the cost side of it, I found clients, they might thinkabout some of the basic explicit costs like, what are my taxes?
(35:32):
What are my insurance?
Repairs and maintenance is one that I see people disregard or really underweight.
And it might be because for a couple of years they don't have any.
And it's like, it feels like there's not a whole lot of downside.
And then all of a sudden there's one big repair and you realize, wow, if I do the math,that just really degraded my return over the past three years when I do the math over the,
(35:57):
you know, and average it out.
Yeah, in kind of extrapolating that, we talk about investors with multiple properties,cashflow from multiple properties.
If one bad thing happens, you tend to have a little bit more income in cashflow.
You can spread your reserves around a little bit more strategically, which creates less ofa, hey, all of sudden I have this house and it's kicking me off income, but now I have to
(36:24):
put a lot more money back into it.
Did I think about the structure of that arrangement correctly?
So I think that kind of, there's so many downstream implications, right?
It's not just, hey, here's what the rent is and here's how much my mortgage is, anythingbetween the difference plus what I pay off in equity is an expected gain.
There's a lot of small things you have to think through.
(36:47):
And then that kind of gets to, you think about income, you think about cost.
and then you kind of end up with a few different numbers that you can use to evaluate, howprofitable is this?
And then from those profitability metrics, then you can kind of think about, well, howdoes that equate to return?
So maybe just share some insight on some different profitability metrics that you get toafter you think about income and costs.
(37:13):
Probably the most important one that we kind of measure for our clients regularly is caprate.
So this is the net operating income of the business or of the property divided by thevalue of the property.
So it's pretty simple.
You're basically just saying, what's my rent?
What are the costs associated with it?
And when I say the costs, costs outside of debt.
So the way you can think about cap rate is if I were to...
(37:36):
If I'm going go back to my $500,000 property, if I were to buy, if I had a $500,000 checkand I went and bought this property, what kind of net income am I going to get on that
$500,000?
What's my, after all my costs and expenses, well, how much do get to take home?
So it's an important number because it's kind of, it's something that you can use toevaluate against other types of investments.
(37:58):
You know, if I were to invest in a treasury bill and I put $500,000 in a treasury bill,
What's my yield?
What am I going to get in a return?
so cap rate is something again that you want to look at and that could be used as acomparison against other investments basically to say what other kind of returns would I
be getting in other investments compared to this?
So cap rate wise, would say, we love to see cap rates in the 10 % range because then youstart, you're basically approaching equities.
(38:27):
I would say we rarely see that these days.
so, you know, realistically cap rates more in the 5 % range, maybe a little higher wouldbe a good place to be.
I will say there's many times we do analysis and we see cap rates at 2%, 1%.
And, um, it's a really, I mean, again, to your point before, when you see that you areessentially.
(38:50):
It's just focusing on price appreciation.
That's what you're saying is I'm not going to make any money on, on, on the rent.
So I'm hoping kind of it's a hope strategy.
I'm hoping that the value of this property goes up significantly over time.
So I think that's probably an important factor to think of.
(39:11):
Realize too, if you have a cap rate at 1 or 2 % and you are using debt to finance thisproperty, you are gonna be cashflow negative because the cost of finance right now is
maybe 7%.
and you are only earning 1 % or 2 % in yield on the property.
So you're gonna be losing money.
(39:32):
Now you might say that's okay because I think I'm making it up in appreciation, but everyyear you're gonna have money going out the door basically between all of your costs and
your debt financing.
So I think that's an important factor when you look at that is you should probably do ananalysis to say, how much does this property need to appreciate?
(39:53):
for me to actually start making money on it and how much does it need to appreciate notonly to start making money but to also actually have a decent return compared to what I
might be able to invest in in other areas.
Yeah.
And this is a situation where leverage tends to help leverage also gives you insight intoyour hurdle rate, right?
(40:13):
Like your expect return kind of has to be above your cost of financing.
Otherwise the math is not going to, not going to work out.
that helps you do a bunch of different things.
How long is it going to take me to break even on my investment?
It's a classic one, right?
[How am I] held in here.
The other one I think gets a lot of focus is building equity in the property over time assomething that people, including myself, we, hey, don't discount the fact that every month
(40:46):
I get $700 more equity.
So that's another way people are viewing these different analysis.
totally agree.
think that's got to go into your analysis of, yes, you might be underwater cash flow wise,but you can almost look at it to some degree as an investment that you're just putting
against the equity.
So you'll eventually hopefully get it back.
(41:07):
based on typical loans, the amortization, you won't see a whole lot of building of equityin the beginning because most of your mortgage payment is going towards.
interest in the beginning and it starts to, you know, it starts to increase as far as howmuch is going towards principal down the road.
So if you're going to use that approach of looking at equity, obviously you're going towant to have an amortization schedule to look to see how much am I building in equity over
(41:31):
time and factor that into your breakeven as well.
So when we're doing our analysis, that's typically what we're looking at is not just theincome, but also the equity because it's, you have to look at both.
few other things that I wanted to touch on here because they're just unique and we talkedabout them earlier in the podcast, but I do think it's important to talk through, which is
(41:51):
some of the tax advantages of real estate that might be a little bit different than whatyou would get if you were, again, using my example of comparing it to and just investing
in a treasury bill or investing it in stocks.
And so the three big ones on the tax side are first, depreciation.
When I buy a property as an investment, I'm able to depreciate the property over itsuseful life.
(42:14):
that for real estate, that tends to be about 30 years.
So I can take about 1 30th of the value of the property each year and deduct it againstany income that I have on that property.
So where that's really advantageous is if I'm earning income on my property and I normallywould have to pay tax on that income, I can shield it
(42:36):
by using some of this depreciation because depreciation is a tax item, but it's not a cashitem.
I don't have to actually pay anything for it.
I just get it as something I can depreciate.
So I think that's an important factor when you're looking at income.
A lot of times income with real estate tends to be, I don't wanna say it's tax free, butyou don't have to pay tax on it.
(42:56):
Let's just say today.
Now what's happening behind the scenes when you use depreciation?
Well, if I have a property that I bought for $300,000,
And every year I can depreciate, let's say $10,000 of that and use it against my income.
After five years, I'll have depreciated $50,000.
My basis in the property, what I paid for it is now not 300 anymore.
(43:20):
It's actually 250.
So I'm just reducing the basis of my product.
Why does that matter?
It matters when I go to sell it.
I have to recap recapture that basis.
So I think that's an important.
factor is that I'm getting some tax benefits now, but I'll have to pay for it later when Isell.
So that's number one, I think, in the tax side of things.
(43:42):
So you can kind of accelerate a lot of tax benefits, even though maybe you'll have to payfor them later.
So there's a value, there's a time value of money in that.
Let's just say, part two to that is that I have a property that maybe has been fullydepreciated, I've owned it for 30 years.
And I get to the point where I say, well, I really
don't really want to own this property anymore.
I'd love to upgrade to a better property.
(44:04):
I'd love to own a bigger property that has more rental income, but I'm going to have tosell my property, pay all this tax because I have no basis in the property.
So now maybe I have to pay, you know, a hundred thousand dollars of taxes to be able totake the proceeds and go buy another property.
Real estate offers kind of a unique opportunity called a 1031 exchange where you canexchange one property for another like kind property.
(44:29):
And by doing that, I don't have to pay the tax.
So I can kind of upgrade my property, if you will.
Now it doesn't mean that I get new basis in the property.
I have to take my old basis, which in my example was zero and transfer it to the newproperty.
But it does allow me to, you know, if I want to sell Apple because I think it's a great,you it's not, it's had its run.
(44:50):
and I want to buy Johnson and Johnson.
Well, there's a tax impact that I have to take to that if I'm buying and selling stocks.
With real estate, I can do it tax free as long as I follow some guidelines.
Maybe if we have enough interest over time, we'll have a whole podcast on 1031 exchangesbecause it's actually a very interesting topic.
just know that it is opportunity available that you don't have with other investments.
(45:12):
That's the exact phrase I expect to come out of the son of a CPA is we can have a wholepodcast on 1031 exchange.
If they're interesting.
Yeah.
There's one other on the tax side, just before we move on.
One other thing I wanted to mention, and we see, we have clients in both these camps, butthe IRS has a very important distinction on how you invest in a property and how you're
(45:37):
classified.
Are you an investor or are you a dealer?
And so I think it's important to understand the differences there and then what that couldmean from a tax perspective.
So are you a dealer?
That basically means, is this your profession to a large degree?
Are you using real estate as like your inventory because you are maybe, maybe I buy 150acres and it's commercially and I'm gonna parcel it off and sell it off and this is my
(46:08):
investment, but I'm actively soliciting, I'm actively marketing it, I'm actually activelyimproving, developing the property.
You can make the same.
argument potentially if I'm buying real estate and fixing it up and that's my business,that's what I'm doing, the IRS will likely view you as a dealer.
The benefit of that and so, well actually let me give it, the second option would be areyou an investor?
(46:33):
So this is more of like, are you more of a passive investor in real estate?
I'm just buying real estate.
I'm hoping for it to go up in price.
I'm collecting rent.
All the things that we've been talking about.
Most of things we've been talking about are investors.
So what's the difference?
The difference is if you are a dealer, the income and expenses are considered actuallyordinary kind of regular income items for you.
(46:55):
So if you have losses, which happens a lot in real estate because of depreciation, you canactually use your losses against your income.
That's an important distinction.
If you have losses and you're an investor, you cannot take your losses and offset otherincome with that.
You're considered passive.
They don't let you do that.
Now, also when you buy and sell, you're getting capital gains as an investor.
(47:16):
When you're a dealer, it's more income.
So there are important distinctions and there's all sorts of people that try to challengethe IRS on this based on what will favor them.
But I think it's important when you're thinking about doing the underwriting on theproperty, you also want to think about taxes and you want to look at your after-tax
return.
And important distinction will be, are you an investor or a dealer?
(47:38):
Yeah, this is the, this is what nobody tells you when you think about getting intofinances.
You think it's all about being a great business person and then you learn, Hey, this isreally about accounting and legal.
And those things oftentimes are not quite as much fun as reading a book about a, abusiness person.
(47:59):
should we jump into an example?
Is there anything else you want to say?
be a great time to kind of take all the stuff we've been talking about and maybe try toapply it to an actual kind of real life example.
Yeah.
And probably the person we should use as a guinea pig most is me.
I just went through it.
And I went through it with some of these unique attributes, right?
I think anytime you evaluate from the, investment you should do so at the very beginningfrom a clean slate.
(48:26):
the first thing you want to do is say, Hey, if I was going, I have to pretend as if I'mgoing to buy this house.
Even if I already own it.
because what you're really doing is you're making another decision to keep owning it.
And this is the thing about investments.
You kind of have to make these choices all the time, right?
I'm going to decide to continue to pursue this strategy, or I'm going to decide to dosomething different, but still doing something.
(48:54):
Oftentimes, if you do it right, is an active decision.
Another approach is just ignore things.
Don't recommend that one.
But so the first thing you want to do is say, hey,
I'm going to look at this from a clean slate objectively.
The second thing is something I mentioned at the very beginning, which is, is thereanything unique about me?
(49:14):
And this is the hardest part about investing is the humility to say I'm not that unique,right?
So I have this property, something that's unique about it is I have a really low mortgagerate.
That was a unique thing that not everybody else has.
And that was probably my one unique attribute.
(49:37):
You might make an argument that I had a townhome in a decently competitive place inWinston-Salem.
So this is a small college town.
A lot of people are moving there from the North, pretty sought after, tends to be biddingwars.
Downside, there was bidding wars everywhere in 2021.
So I'm not really sure I can view that as, is that unique?
(49:59):
So then you go into an analysis where you kind of think about exactly what you talk about.
Let me look at my purchase price.
One of the things that you mentioned, Pat, was a lot of the metrics we use are relevant tothe value of the property.
In real estate, value is not reflected every day like it is in stock markets, right?
(50:23):
So here's where I tend to see
And I caught myself doing this, being a little picky about what number am I going to use?
Am I going to use the price I paid?
Or am I going to use the expected value of the property today?
It matters from some of these metrics.
And this is where you can see the challenge of, well, it's this, I don't know.
And you kind of cherry pick and jump, jump between the two.
(50:45):
So you think about, here's the price I pay.
Do I have to incur any costs to get it ready?
for market.
Long story short, we decided to not rent it out.
We sold it mostly because I needed the down payment to buy another house as a primaryfactor.
But when I bought my new house, the sellers definitely had some work that they had to doof a pretty significant dollar amount to get the house ready for us to buy.
(51:13):
So there oftentimes is work that you put off and you don't quite recognize.
So we're going through, you have the prices that you're paying, you have the financingdecisions.
Again, this is kind of an asset, so we think.
And then here comes a lot of these different assumptions that have to be made.
(51:33):
And this is where, again, you want to be really, really conservative, right?
So what's the true rent that I can get?
And this is again, a spot where...
there's a ton of information out there in the marketplace.
You could go to Zillow and say, I'm looking for rental properties.
Here's.
Let me look at some options and see what people are listing them for.
(51:54):
So go in, find what we think is a reasonable comparison.
Challenge of already owning a home is I probably thought it was a little better than maybeit would be to the next person, right?
Like I love that house.
Vacancy is a really tough one.
think you can, again, we kind of reference that.
And then all the costs, right?
(52:14):
And I think one of the big...
there's kind of two hidden costs.
The first is...
the repair costs that you mentioned, what happens if something goes wrong?
How do you think about building some reserves to pay for that?
The second is we didn't live in the state, so we only have one option, which is propertymanagement.
But it tends to be about 10%.
(52:34):
That's a pretty significant cost that you're going to have to pay in exchange for nottaking on headaches.
That 10 % is going to matter a lot in
your ability to make money on the property relative to the opportunity cost.
you think about all these costs and then this allows you to do some of those metrics thatwe were talking about, right?
(53:03):
So what's my net operating income?
It's positive.
It looks like a great number.
I think this is one of the big traps is you're looking at, hey, what's my mortgage?
What do I pay versus what do I get in rent?
And that's where you tend to see some pretty big, nice numbers that look great.
(53:23):
When you zoom in and you think about some of those costs, the cashflow doesn't look quiteas great.
Even using leverage to cash on cash return, not as great.
Cap rates were around 3%.
So you kind of mentioned like, hey, this is what we're seeing with the low mortgage rate.
You're still kind of targeting a 3 % mortgage rate.
(53:45):
The 1 % rule, we were at half of that, which kind of just tells you price appreciation.
And so if you can't make the numbers work on a spreadsheet, that probably tells you a lotabout you're trying to force an investment.
And when you listen to all the greatest investors out there, they say things like, turneddown 90 % of the things that we look at.
(54:12):
Why?
Because it is so hard to find something that the market hasn't already priced in.
And again, you go back to, what was the theory?
What did I expect?
Have I expected this outcome?
Opportunity costs?
Could I have put the money to better use?
Yes, I could, because my family would like a place to sleep.
(54:34):
So just one example, again,
About 10%, over a hundred clients of Greenspring have direct invest private real estate.
The numbers, you want to be very thoughtful and work hard to think about those.
And then you want to think about what are those other extracurriculars?
(54:55):
Cause at the end of the day, money's not just dollars, right?
Is it an investment or am I going to get some alternate use out of it?
Am I going to be able to allow my kid a place to stay?
Am I going to be able to vacation there?
when I'm not renting it out.
These types of things are gonna come into play after you look at the numbers.
Yeah, it's a great, thank you for sharing the kind of your specific circumstances.
(55:18):
And it sounds like you came to the conclusion that the returns were not commensurateenough with kind of the risk that you were gonna have to take along with, you know, other
competing sources of capital that are competing investments for your capital.
I think it's the conclusion that you got to, you know, we talk about how many of ourclients invest in real estate.
Well,
There's another element to it, which is there's a lot that don't, you know, if, about 10 %do, then that means 90 % have not, decided to.
(55:44):
And I think that's an important, number to think about too.
It's not that there is a right or wrong answer with this, but you do also have to kind ofknow yourself to a degree.
And owning real estate is not a passive investment.
I mean, I think people have heard that before it's, it really isn't, you have to bewilling, even if you have a property manager to deal with properties.
I have a family member that owns an investment property that is managed by a propertymember.
(56:09):
And I can tell you it is the least thing from passive that you can think of becausethey're getting calls all the time about repairs that may be made to the property.
Now they may not have to do them all, but the part of the brain that has to kind of justdeal with the decision-making all the time of what do we do?
Should we make this repair?
Oh gosh, this person's not paying rent.
(56:30):
What do we do?
Do we have to evict them?
There are just these decisions that have to be made that a lot of times people don't wantto make them.
Or they look at the returns and say, it's not worth it for me to have to deal with this.
again, there's not a right or wrong answer.
I think you had some really good insight in that if you are going to decide to investdirectly in real estate yourself, you should think about what's kind of my competitive
(56:53):
edge here.
What do I have that can make this a really good investment?
could be
Maybe you're in a great area that you know really well and has great numbers when you dothe underwriting.
It could be a low mortgage.
It could be, you you already own this property and there's some advantages to it.
You know, there's a lot of different things, but if you don't know and you're just like, Ithought I'm just thinking of, you know, buy a property to rent it out and, you know, one,
(57:15):
do the underwriting.
If the numbers don't make sense, there's a really high likelihood that it's not going towork out very well.
So.
you know, just make sure you're mindful about investing before you jump into it.
That's right.
And, you know, one of the examples you gave is we work with a lot of real estatedevelopers.
We work with a lot of smart people in private equity.
(57:36):
And when you see their returns on Excel, they know it's really hard to get those on a onedeal thing.
First year is pretty easy to model out.
After that, there becomes a lot more uncertainty.
Right?
So this is one of the reasons why you think about
their expected return number, it's bigger than the realized return they're actuallyexpecting to get.
(58:02):
It doesn't typically work the other way.
And this gets into the nuances of returns with skewness and volatility.
But it is very helpful to have a significant dose of skepticism around, what's the truerisk equivalent?
(58:24):
to my investment and if I'm using leverage, comparing it to something with maybe lessleverage, I think that's an important consideration.
So what's the true risk equivalent?
And then how do I factor in challenges unique to me?
Like, am I taking on illiquidity?
I should, as an investor, I should want higher return in exchange for less ability toaccess that, unless it's such a small portion of my net worth that.
(58:50):
I disregard, which tends to the opposite for people if you go back into why do people getso attracted to real estate?
It's because the use of leverage can really amplify your ability to grow your net worth ifeverything triggers exactly right.
Absolutely, yeah.
I think it's a good place for us to end and maybe we'll have a geeky conversation abouttax free exchanges at some point in the future if people have an interest in that, but it
(59:19):
was a fun exercise going through.
I think it's a question that a lot of clients have.
And if you're a client of Greenspring, would say,
and you haven't gone through the analysis with your advisor, I would encourage you to havethese conversations because we do this every day.
And if you're not a client, you want somebody to take a second look, we're happy to help.
Yep, absolutely.
(59:39):
All right, thanks Pat.
Thank you.
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