by Adam Dawson
Well I hope you’re still up for suspending judgment because this is the story you’re really going to get me for. I am curious to see what everyone thinks of this, but I do anticipate some disagreement on this topic. Our second rental property was not an accident or a stroke of bad economic luck. We went into this one full speed ahead. Here’s the story.
One of the big events in the Austin area in the past year has been Michael Dell’s attempt to buy back his company from the public market via a leveraged buyout. In fact, shareholders just today voted to approve the deal. If you aren’t familiar with an LBO, it’s essentially a way to buy a company using mostly debt that is financed by the expected cash flow of the company. The buyer puts in a relatively small down payment, and over 3-5 years, uses the profits of the company to pay off the debt, and is left with ownership of the whole company free and clear. In this deal, Michael Dell is putting in about $2 billion of his own money, and will be the largest investor in a company worth approximately $20 billion. To make the debt payments, he will lay off thousands of employees to free up cash.
When I looked at this deal, it really bothered me. I was upset that Mr. Dell, simply because he could throw in a bunch of his own money and arrange a bunch of financing, could turn his $2 billion into $20 billion, essentially without adding any value to the company. If he can innovate, and grow the company, he will do even better. But the bread and butter of this deal is simply a financial transaction. If he simply maintains the status quo at Dell, he will triple or quadruple his money in a few years. Don’t get me wrong, I don’t begrudge Mr. Dell his money or his decision to use it to make more money. But I do resent the fact that so many workers will lose their jobs in the transaction, and I especially resent that the average worker/investor is more or less limited to investment options that may return somewhere between 3% and 12% instead of having access to the types of arrangements that people in Mr. Dell’s position can pull off. Maybe I’m just jealous.
So I got to thinking, how can an average investor like me use leverage to grow money the same way Michael Dell can, without having access to billions of dollars? Is there any way I can put my small retirement account to work by buying an asset worth 4-5x as much as I have, that will pay for itself in a few years from its own cash flow? The only answer I could come up with that is attainable for people like me is real estate. I know you can buy stocks on margin, you can buy an existing small business, but these options seem way too risky for me. To mimic a true LBO, you need something that is highly debt-financed, with predictable passive cash flow, and a 3-5 year payback horizon. The rulebook says investment properties require at least 25% down which leaves 75% financed. With that sort of leverage, I’m starting to feel like a tycoon after all.
That’s right. I am talking about an investment strategy that eschews the conventional wisdom of slow growth over 35 years in favor of something that throws off 30-40% and is debt-financed. I don’t expect everyone to agree with me. I do know there is a sizeable risk, but as I mentioned in a previous comment, I think I was born to be in real estate – because all the heartburn and pain that other people go through seem to be natural for me to deal with. I’ve made mistakes but I’ve learned a lot and I think it’s going ok so far. (A special note to reader Cathy C. – your comments and suggestions are NOT in vain! I’m not a perfect landlord and your experience is also instructional for us! Thank you!). There is a commercial that plays on the radio in our area that says more millionaires were made in America through real estate than any other means. I wonder if it’s true.
This spring, I started looking into additional real estate options. Austin properties didn’t make sense. Prices and taxes were too high, and the returns are all based on expected increases in value, not from predictable cash flow. I’ve tried the speculation route and I’m not interested in that kind of deal. I want cash flow. Turns out that Indianapolis is one of the best cash flow markets in the country. Not to mention, I have a fantastic property manager in Indy already. I started looking at rental properties available on the market and did some analysis in trusty old Excel. I found that many properties would rent for twice as much as your monthly expenses, given the low interest rate environment of early 2013. I settled on the 2% rule – I would only look at properties where the monthly rent is 2% of the purchase price. Many investors use a 1% rule but the 2% rule is a lot pickier and narrows the choices to high cash flow properties. I also limited my search to properties with renters already in place – which signals rental demand and also eases financing.
So I made an offer on a duplex about a mile from my previous property with a 2.2% rental rate. They countered, and I came right back with the previous offer. I wasn’t desperate. But to my surprise they accepted the offer! I couldn’t believe the offer was accepted, the inspection passed, and financing was a breeze. So in a few weeks I became the proud owner of a second house – this one a duplex.
This property, with both sides rented, brings in $1450 per month and the costs are about $650/month. This is a much better cash flow than the other property. Since this is part of our retirement strategy, we won’t be touching the money this property brings in. This time I paid 25% down out of my retirement savings and made sure we could cover expenses in case it went unrented for a while. The idea is that in 3-5 years, we will be able to either pay off this property or use the proceeds to pick up another one or two units. In a normal year, this ends up being a 56% cash-on-cash return – much better than my 401k usually does! With maintenance and vacancy figured in, I’m expecting 30-40% returns realistically.
We’d like to eventually have 5-7 properties with similar characteristics, which should provide enough cash flow to live off of in case I lose my job or we want to retire early. We have 2 so far, plus our guest house. Just to be clear, we won’t be tracking the property debt on this blog. I am ridiculously debt averse when it comes to personal debt, but I have a completely different opinion of debt for business purposes. When it comes to business/investing, debt is just a tool that figures into the cash flow equation.
So that’s the story of our 2nd rental property. There are many other personal factors that figure into this plan of ours. One has to do with being geographically mobile, another is our desire to be free from the corporate rat race. We may talk more about those in the future, but for us, a few investment properties seemed right as part of our retirement plan.
