To truly create wealth and get the most out of your investment dollars you must invest for the long-term. A proven strategy for long-term real estate investing is the “Invest and Reinvest” strategy. This is a wealth creating concept for investor where the in initial investment is never liquidated. Instead it is transformed it into multiple properties without additional cash out of pocket. The equity in a property will allow the investor to acquire more properties in a tax deferred manner by utilizing a 1031 Exchange or by refinancing. Over time enough equity will accumulate in the property to sell and buy two properties.
For example, an investment home worth $175,000 is purchased with 10% down, or $17,500. Total cash investment would be approximately $19,500 including closing costs. After 5 years at 7% appreciation the home is worth $245,447. The proceeds from the sale are $87,947, which could be reinvested evenly between two homes with $43,973 down on each. If the new homes cost $250,000 each there would be sufficient proceeds to put 15% down and cover closing costs. The investor now owns 2 homes, but the initial cash investment remains the same, $19,500.
Reinvest Example
Sale Price
$175,000
Cash Down (10% + $2,000 Closing Costs)
$19,500
Loan Amount
$157,500
Value after 5 Years at 7.0%
$245,447
Proceeds from Sale *
$87,947;
* This examples does not consider realtor commissions which might reduce proceeds from sale
If the investor chooses to sell the initial investment property, the gain on the sale is taxable if used for anything other than buying more investment property. Alternatively, investors will refinance or take a second loan on a property to liquidate some of the equity. The cash is then used to invest in more property. Both techniques allows the investor to take funds in a deferred tax manner.
A 1031 exchange is used in circumstances when the investor prefers to sell the property, when there is an active selling market, or when the investor needs to liquidate the entire amount of equity in the property. Refinancing or acquiring a 2nd loan is used in circumstances when the owner prefers to hold the property or when the investor wants quick access to funds.
Refinance or 1031 Exchange?
PROS
CONS
1031 Exchange
• One of the few tools available to defer or eliminate taxes from the sale of property
• Deferring the tax makes more money available to invest in another property
• You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain
• Transaction subject-to strict rules & timelines
• Must involve a 3rd party intermediary for approval and to facilitate the transaction
• Requires investor to sell the property
• It is a long process from selling to buying
Refinance or 2nd
• Allows liquidation of equity for investing without having to pay taxes on the gain
• Can be done quickly without having to wait for the sale and closing of the property
• Allows the investor to hold onto the property
• No complex rules or restrictions to follow
• Using refinance money to acquire property creates 100% financed investments
• Creates less cash flow because of greater leverage
• Closing costs can make it expensive
• Cannot access all equity as financing company requires some equity to remain in home
Good real estate investments create both positive cash flow and steady appreciation. However, each investor has his own balance he prefers when it comes to cash flow and appreciation. The amount of leverage on a property has a direct impact on cash flow. Smart investors manage their real estate assets by balancing the percentage of leverage in their portfolio. The optimal balance point varies based on personal preferences, goals, philosophies, and comfort levels.
Conservative Portfolio (0% to 50% leverage):
A conservative portfolio is characterized by low amounts of leverage, and high cash flow generation. The highly conservative investor would be more likely to pay off a mortgage and receive cash flow, or to put more cash down on a real estate investment. Conservative investors will typically hold a property for a much longer time period than more aggressive investors. Conservative portfolios generate lower returns on investment because they do not capitalize on leverage. Subsequently, conservative portfolios generate more cash-flow than less conservative portfolios.
Moderate Portfolio (50% to 85% leverage):
A moderate portfolio will generate good cash flow, but will finance the overall portfolio with significant leverage (debt). A moderate investor demands some positive cash flow, but also wants significant leverage to increase the return on investment.
Aggressive Portfolio (80% to 100% leverage):
An aggressive portfolio will create break-even or possible negative cash flow and high percentages of leverage (debt). The aggressive investor is not concerned about cash flow and is much more interested appreciation. An aggressive portfolio is financed initially with 90% to 100% debt. An aggressive investor will sell or refinance a property after enough equity is produced to reinvest.
Investors are interested in homes that create positive cash flow and that appreciate in value. These are the two most basic reasons for investing in real estate, and both are required for a sensible investment. However, each investor has particular balance they prefer between cash flow and appreciation. It is important to determine the right balance for you. Always keep in mine the direct correlation between cash flow and the mortgage product you select and the terms of your loan.
Investments that generate a large amount of negative cash flow are speculative investments, and are not something we would recommend. Negative cash flow limits the number of real estate investments you can make, and will put the investor at the mercy of the market. However, the amount of positive cash flow desired differs greatly amount investors.
The two factors that greatly affect cash flow are the particular home purchased loan product used to finance the home. The higher priced investment homes in the Atlanta market appreciate faster than the lower priced investments. However, they tend to generate less cash flow. Investors who buy in higher priced homes do so for the appreciation and are willing to sacrifice some cash flow.
The more money put down on an investment the more cash flow it will generate, but the over all return on investment will be lower. The example below shows the total return on investment for a 10% down and a 20% down investment scenario.
Comparison between 10% and 20% Cash Down Investment
Example 1
10% Down
Example 2
20% Down
Sale Price
$175,000
$175,000
Cash Down
$17,500
$35,000
Buyer Paid Closing Costs *
$2,000
$2,000
Total Cash Investment
$19,500
$37,000
Loan Amount
$157,500
$140,000
Principal & Interest @ 6.825% *
$896
$796
Escrows for Tax & Insurance
$200;
$200
Total Payment
$1,096
$996
Rent Amount
$1,250
$1,250
Management Fees (7.0%)
$88
$88
Net Rental Income
$67
$166
Net Cash Flow after 5 Years
$4,003
$9,975
Value after 5 Years (at 6%)
$234,189
$234,189
Gain in Value
$59,189
$59,189
Total 5-Year Gain (Cash + Appreciation)
$63,193
$69,164
Total Return on Investment
324%
187%
* 5-year ARM interest-only loan is used. This example assumes 100% occupancy
Although the 20% down investment generated about $6,000 more cash flow over 5 years, the 10% down investment shows a 137% better overall return on investment. Another way to look at it is if the investor purchased 2 homes at 10% down instead of 1 home at 20%, his cash out of pocket would be about the same, but the overall return on investment would be approximately 648% verses 187%.
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