Compounding your investments with discounted Land Contracts
By: Mehran Aminzadeh October 2010
If you read Robert Kiyosaki’s books or played his Cash Flow game you know he emphasizes cash flow as the most important parameter for any investment or business. The following examples illustrate two long term buy and hold scenarios that you may consider for investing in Real Estate 1) a rental property and 2) discounted performing note or land contract (LC) with a tenant-buyer in place. These investments are great vehicles for retirement funds such as 401K, IRA, or Roth IRA. In these examples we are going to assume the investor uses his capital to make an initial investment (such as IRA) in a rental property or discounted land contracts and does not add more funding to the investment except the income from the properties.
For the purpose of making some appreciation assumptions for the future let’s examine the historical trends in CA. Figure 1 shows the median single family home sales in CA and U.S. From 2000 to 2006 the median home in CA increased 132% with an average of 22% per year. Between 1990 and 2006 the median home in CA increased 180% in 16 years or average of 11% per year. Real estate is cyclical and buying an asset which produces stable income when the market is low is certainly a great way to build wealth in the long term. Historically 70% of all wealth created in the world is created by investments in real estate.
Figure 1.
Median sales price of single family homes in CA and U.S.
Rental Property in CA
Let’s assume you plan to buy a rental property in CA and you purchase it with your IRA funds for about $260,000 and you want to benefit from cash flow and cyclical CA appreciation. While it may take several years before the CA housing market starts to appreciate if we “assume” that you can expect an average of 11% increase per year in the next 10 years then a median property of $260,000 will be worth $546,000 in 10 years. This is not a prediction or educated guess we just want to illustrate a basis of comparison assuming we experience the same average trend as the previous up trend. You may think that is an unlikely scenario after the recent sharp price declines and may be overly optimistic. For the purpose of our example we assume the 10 year trend will follow the last uptrend. Table 1 shows assumptions for this rental property and income and appreciation. Assuming that you can get $1500 rent with 5% vacancy for your CA rental property. After taxes, insurance, and repairs it is likely that you will get about 4% cash on cash return if you bought this property cash with no loans from your IRA (about $10,5000 annual cash flow after taxes and repairs). The net cash flow for this property is 4% of purchase price. So you will experience a 15% average return in 10 years. This hypothetical scenario in 10 years will result in $546,000 sales price (11% average price appreciation) plus 5% cash flow per year for total of $651,000. That is 150% return in 10 years. While a 15% average return is considered a really good return you cannot buy another property in CA with the 4% annual cash flow for this example. So you cannot benefit from compounding your cash flow. The majority of the gain comes from relying on the appreciation. If you assume that you can rent this property for $2200 rather than $1500 it increases the cash on cash return to 6.8% yet it is still not large enough to buy more properties in CA over a 10 year period.
Table 1.
Shows assumptions for a rental property.
Discounted land contracts in Midwest and East coast
Now let’s consider you were able to buy 10 discounted land contracts at $26,700 each for a total of $267,000 in the Midwest with the assumptions listed below. These numbers represent current market value on an average discounted note with a couple months of seasoning. The numbers are realistic if you have relationship or access to the right company who is doing bulk REOs.
Table 2A.
Assumptions for buying 10 discounted land contracts.
Assuming the 20% vacancy you get an annual income of $38,400 with 10 properties as shown below. The tenant-buyers have a stronger motivation to stay in the property so it is very conservative to assume a 20% vacancy. We also assume that there is no appreciation on the properties. In reality when the properties appreciate even though the tenant-buyer benefits from appreciation it increases the likelihood of early loan pay off due to refinancing or sale. If you were to re-invest the cash flow in additional properties at the end of each year you can own 19 properties by the end of 5th year. In this example if you were to continue re-investing in additional land contracts you can have 37 land contracts after 10 years! The compounding impact in this example can grow your IRA very significantly. The existing tenant-buyer in the property makes the tax payments, insurance, repairs, and benefits from appreciation. This re-investment compounds the growth of your investment or IRA. The assumptions are certainly simplistic and the market will shift in 5 to 10 years however this illustrates the significance of compounding of a highly cash flowing investment. After 10 years the $267,000 investment increases 438% to $1.16M (significantly more than the rental property example). The average annual ROI for both examples is about the same 15% vs. 14% so why does the 2nd scenario results in significantly more ROI? In case of rental the majority of the wealth is coming from appreciation and more importantly there is no compounding possible because of limited cash flow. In contrast with discounted LCs the wealth is gained by compounding. This gap will certainly grow if we consider longer investment term. It may seem overwhelming to manage several LCs and tenant-buyers if they are scattered in multiple states. In fact asset management or property management companies who commonly use mobile ground crew when needed are capable of managing this effectively. The fact is that you are dealing with tenant-buyers who take care of the property since they want to own and pay it off and not tenants so that simplifies the management significantly.
Table 2B.
Initial investment in 10 discounted land contracts will grow quickly when the income is re-invested.
Below is an outline of some of the differences between a rental property and holding notes or land contracts. While each strategy has its own advantages and draw backs savvy investors are open to utilize both strategies to benefit from compounding of cash flow on land contracts as well as cyclical appreciation of a rental property. There are several simplified assumptions made in this comparison. As a minimum the goal of this contrast is to get you to think about adding discounted land contracts to your investment options which can complement the strategy of investing in rental property. The compounded cash flow will give you significantly higher return than holding rental properties. By combining the two strategies rather than a single one you increase your odds of creating wealth in your IRA. Since the current real estate market provides the opportunity to buy the land contracts at a discount you can lock in build-in equity and re-invest the cash flow to super charge your investment or IRA.
If we consider using leverage for the rental property scenario and borrowing 70% from a bank with a 30% down and buying 3 rental properties we still cannot use compounding to buy more properties for 10 years since the cash on cash return is still very low. With the leverage of borrowing when the appreciation comes back to let say about 11% average per year (over a 10 year period) then the total ROI for the 3 rentals can approach the same level of return as multiple discounted LCs. However, that is not be a fair comparison since using leverage can also mean taking more risk in case the market goes south.
Table 3.
Comparison of rental properties vs. discounted land contracts.
In conclusion while the current extreme real estate market has created an amazing buying opportunity you are encouraged to take advantage of it while these discounts are available. With performing discounted notes and land contracts you become the bank and free yourself from the responsibility of repairing properties or paying for taxes and insurance and you maximize your cash flow and compounding. You no longer are relying on timing of real estate appreciation and can diversify by holding several land contracts in different markets. Contact Summit Solutions Team to learn more.
