Cash Flow of Smart Debt Guy vs. Cash Guy.
The previous post was about equity growth but consider cash flow and tax benefits too. To read the back story click here.
Smart debt guy gets to depreciate five houses. Cash guy depreciates one house. Assuming all of these 100K houses have an improvement (structure) value of 80k and land value of 20k. This means that each house has an annual depreciation of $2,909.09. The schedule for depreciation of residential property is over 27.5 years. This means that you can claim a deduction of this amount even though you likely saw some appreciation in value. So Smart Debt guy claims a total of 14,545.45 in total depreciation for the year. Cash guy only claims 2,909.09 in depreciation. This is a reduction in their income which equals less taxes paid.
Smart Debt Guy’s cash flow
We’ll assume a rate of 5% on these mortgages for Smart Debt guy. The loans will be 30 year fixed-rate. This means that the payment for P&I (Principle and Interest) is 402.62. We’ll assume 70 dollars per month for property insurance and 125 dollars per month for taxes. This means the total payment PITI (principal, interest, taxes and insurance) equals 597.62. We’ll assume this is a one percent deal which means it rents for 1% of purchase price so 1,000 dollars per month. This means that the gross cash flow per house is $402.38 with leverage. Now with cash what is it? Well, we still have taxes and insurance so it will be $805. So Smart Debt Guy makes $2,011.90 in monthly gross cash flow over his portfolio compared to Cash Guy’s $805. We won’t get into the other expenses such as vacancy, maintenance, and capital expenses in great detail as there is a lot of disagreement on what should be estimated for each of these. Consider it a safe bet that at least a couple hundred dollars per month should be set aside for these expenses (subtract 200 dollars from the cash flow of each house). This would change the numbers to net cash flows of $605 for Cash Guy vs. $1,011.90 for Smart Leverage Guy. This brings the actual numbers closer. But what about pay down? $90.12 per month goes towards our favorite forgotten bank account called “equity” for each house in Smart Debt Guy’s portfolio. This is the “P” of “PITI”. This adds another $450.60 in equity gain monthly over Smart Debt Guy’s portfolio. Cash Guy does not get this because he paid for all of his equity up front.
Year #1 for both fellas
Let’s assume stagnant growth with no appreciation in year one.
Cash Guy’s situation after one year
This means that Cash Guy makes $7,260 in cash flow, $2,909.09 in depreciation and no equity growth. After claiming the depreciation ($2909.09) , he has taxable income of $4,350.91 (net cash flow minus depreciation).
Cash Guy made $7,260 in cash flow and zero in equity growth. He’ll protect some of his income from taxes by claiming depreciation and will end up with a taxable income of $4,350.91
Smart Debt Guy’s situation after one year
Let’s look at Smart Debt Guy’s cash flow. He’s got $12,142.80 in cash flow, $14,545.45 in write-offs for depreciation for a net taxable income of NEGATIVE $ 2,402.65 and positive equity growth of $5,767.20 (from debt pay down by tenants). He has a taxable income of negative $2,402.65. Mind blown, right?!! This loss can be used to offset income from other sources with compliance with all tax laws (seek advice from a CPA – I’m not one). But I’m right. Haha.
This means that Smart Debt Guy increased his net worth by a total of $17,910 (cash flow + debt pay down) but is showing a legitimate loss for tax purposes.
Year #2 with a gain of 5% in house prices but stagnant rent growth
How does this affect ol’ Smart Debt Guy and Cash Guy? Well Cash Guy sees an increase of 5000 dollars, or 5% ROI. Otherwise his situation remains the same as last year.
Smart Debt Guy Sees an increase in his net worth of 25,000 dollars, or 50% ROI (remember from our last post he invested 10,000 in each property or 50,000 total). And this is just from the increase in equity from appreciation. He also sees debt paydown (additional increase in equity) of $6,313.55 across his portfolio. Again he will claim a loss for tax purposes but will see an actual massive increase to his net worth.
Neither investor has a change in their tax status this year as they haven’t sold a property or seen a capital gain. What do they do if this continues? One day they could each pull equity out in the form of a cash-out refinance tax-free. Loans are tax free! I think if these guys hang out together for long Cash Guy may even see the value in using a little debt to get more leverage working for him.
Year #2 with a loss – let’s replay year 2 as though it actually was a year of loss.
Let’s assume we are back at our starting values and in year two we see a 5% decline in value. What happens to our friends’ portfolios? Cash guy loses $5,000 in equity. Cash Guy’s loss is in equity he paid for when he purchased the house.
Smart Debt Guy loses $25,000 in equity. Smart Debt Guy’s loss is in equity he created. He can lose another ten percent in value before getting into the 10k he invested in each property. This is a tough concept to explain but for each house he essentially borrowed the first 75,000 dollars in value per house, paid for the next 10,000 in value, and created the last 15,000 in value. So if he sells at this 5% loss point he will sell for $95,000 and pay off a loan for 72,630.77 (original loan amount minus principal payments made over two years). This will result in $22,369.23 to Smart Debt Guy per house. But he only paid $10,000 for each house. So he will profit $12,369.23 per house or $61,846.15 after a year of “loss” in the market.
I hope this helps you to see the way that debt can leverage you to greater returns.
This is an oversimplification for the sake of explaining a difficult concept. All of these numbers can be manipulated to see different results. We also did not account for closing costs – which are significant for real estate transactions. Also, the depreciation that was claimed will be recaptured at the time of sale. UNLESS….. you do a 1031 exchange to defer the taxes and reinvest in more property. Isn’t this stuff exciting!? We will get into 1031 exchanges in the future but I think this is a good stopping place for today. This post has a lot of numbers in it. I recommend that you re-read it if you don’t understand any part of it and leave a question in the comments section if I can offer some clarification.
For every investment there is an opportunity cost. There is the thing you could have invested that money in instead. Long-term real estate is a unique opportunity because the rules are slanted in your favor compared to other types of investment. You have the tax code that clearly favors it and you have access to leverage that makes a mediocre investment a truly amazing opportunity as was demonstrated through our friends Cash Guy and Smart Debt Guy.
Remember that debt can equal risk. Putting money in the bank to be eroded by inflation can also be a risk. Not ever taking any chances or being afraid to try something may be the biggest risk of all as this is akin to not fully living. It doesn’t have to be real estate but I urge you to follow your passions and interests. And of course, “Keep the main thing the main thing.”