I’ve struggled with the right way to tell this story. I’ve attempted to write about my privilege in the past, but I’ve never been overly happy with the posts. A lot of people, especially my own family, tend to tell me that I’m “good with money”. I feel like part of that is because my idea of a super fun Friday night is reading about money on the internet. The thing is, I didn’t start out as a “money expert”. I think that writing directly with some actual numbers is just the best way to do this. The big numbers here are public record. Therefore, I don’t see a reason to try to keep it a secret.
In 2010, I bought a 2 bedroom condo in Southern California. It was less than 5 miles from where my job was. I bought a condo not because I was some investment wizard, but because my dad scribbled on some paper and showed me the comparison of costs of me paying rent vs. me paying monthly expenses of a mortgaged condo after tax deductions. Thanks dad! In other words, he was probably just gently telling me that it was time to move out.
When I started looking at real estate, I did not have any retirement accounts. There were no taxable brokerage accounts. I had somewhere between $15,000 and $20,000 in an ING Direct Orange Savings Account. It might have even still been paying over 2% around that time.
I Didn’t Know A Lick About Investing.
My obliviousness to investing during my college years (2004-2009, ages 19-24) shielded my life savings from one of the more massive drops in U.S. equities during my life time. You could say that was the very beginning of a long road of “good financial luck” as I began the process of distancing myself from being fully financially dependent on my parents to where I am today, talking about taking an extended break from work.
That’s huge. How did I get there? Mostly because of real estate and debt.
I’m sure that my dad might have believed that it was a “good time to buy” relative to what the local real estate market had looked like in the years prior. Looking back, I certainly recognize that it absolutely was. But I had no idea about any of that at the time. I wasn’t counting on real estate appreciation when I made my real estate investment. What I did understand was that by having a cheap mortgage instead of rent, I would have more cash flow to blow on pizza and chicken wings. So I bought a condo. And potentially a lot more pizza vs. if I were a renter.
When I got tired of living there, I rented it out for a couple years. I could have sold it right away, but I didn’t go that route. It actually went up in value some more. This article from San Jose State University has a great explanation of Internal Revenue Code §121(b)(4), the tax code exception which allowed me to rent out my condo for a couple years and still keep all of the capital gains tax free. I actually didn’t know about that part of the exception until I did research to file my 2015 taxes, so that was pretty exciting. I thought I had to split the gain between 60% personal use and 40% rental use, and I wanted to sell before it was 100% rental. At that time, I totally thought that renting it out (and making the gain partially taxable) was going to end up being one of those financial blunders I quietly ignore on this blog. Instead, it was yet another turn of random good luck in my personal financial life. Ha.
Accidental Landlords Who Recently Converted MUST Analyze Potential Tax Free Gains vs. Cash Flow
Now that you know about §121(b)(4), those of you with recent accidental converted rentals of your own, it’s always worth doing some analysis on how much of a tax free gains you are sitting on and how many months of cash flow that is equivalent to. For my specific situation, I was charging $1500 of rent less a 10% management fee. So, I had $1,350 of rental revenue.
Why are we talking about revenue though? Leveraged real estate has associated costs. The asset itself also has it’s own costs, too, in the forms of property taxes, insurance and HOA fees.
If you consider a $750 mortgage, $250 HOA and $112.50 per month of property taxes, you’re looking at $237.50 of monthly positive cash flow against $1,350 in revenue. I routinely generate $200 just for signing up for a new bank or brokerage account!
What about Principal Pay Down?
The money nerd readers might want to remind me that principal pay down on a real estate asset is just transferring my cash from one of my assets into another. That’s true. But, I would remind you that any cash trapped inside of an illiquid real estate asset is cash that I could instead be investing in common stocks or mutual funds containing common stocks that pay me dividends and historically grow at a rate that is greater than inflation. Only way to access equity in real estate is to take on debt.
After my five years of property ownership, I ended up with $111,000 of after-sale equity proceeds. That would be considered a “windfall” to the vast majority of the American population, and I am no exception there. I mean, when your pre-tax salary has been $52k-$57k for the majority of your career, receiving a wire transfer that’s more than double your annual after-tax salary is kind of a big deal.
That is equivalent to over *38 YEARS* of what was at the time current monthly positive cash flow on the condo.
I could have held on because I wanted the emergency contingency of having a paid-off place to live mortgage free in the year 2026. But, that’s an emotional response.
But if you still want to think about this emotionally, there’s a fiscally superior option. You could recognize that the equity proceeds, if captured immediately, were equivalent to several years worth of present day rent if I was willing to move somewhere less expensive. That pays for a lot of flights, trains, or gasoline to visit family here in California.
That doesn’t even consider the potential investment growth from those equity proceeds.
Was there even a question if my condo should have been kept in service as a rental property? Well, apparently somebody thought so because they bought it from me for a 55% higher price than what I paid. They purchased WITHOUT leverage and promptly placed a rental ad for basically the same price. Yikes. Now, those people get to rent it out for the same amount, and they get to pay 55% higher property taxes than I ever did. I’m very proud that I was able able to collect a huge wad of cash and bring in some additional revenue to my County and local Schools on someone else’s property tax bill. Win win.
Purchase Price: $135,000 in the Spring of 2010
Sale Price: $210,000 in the Summer of 2015
The condo itself appreciated 55.5% over my five years of ownership, an average of 11.1% per year. Of course my capital gain on the asset was much lower than $75,000. That’s because I had a solid $14,000-ish in closing costs from the sale, another $12,000-ish for the combination of purchase related closing costs and some capital improvements I had made along the way. I also had just over $8,000 in depreciation deductions that I was on the hook to send back to the government. But depreciation is completely a wash because I had taken that $8k of tax deductions over the previous few years. For you number nerds, here’s exactly what that looks like:
Why’d you sell!? California Real Estate Always Goes up!
That is certainly the myth I hear often. Tell that to the people prior to me who paid $350,000 (!!!!) in the Spring of 2007 and had to do a double short sale to me in the Spring of 2010. That’s a loss of 61.3% over the course of three years, or 20.4% per year. And two banks had to eat a loss on that in order for them to sell it to me. The next time I complain about short sales taking forever and generally being a pain in the ass to deal with as a buyer, please direct me to this post and the following screen shot so that I promptly just shut the hell up.
The Trifecta of Leverage, Parental Subsidies and Government Subsidies
My down payment on my $135,000 condo purchase was $27,000. My parents gifted me $13,000 of that $27,000. At that time (calendar years 2009 and 2010 only), the United States Government was giving out $8,000 to new homebuyers like you were a kid in a candy store. AND, it was refundable. A Refundable Tax Credit means that the government sends you a pile of cash even if you don’t have any tax liability to offset it. You could even buy a condo in 2010 and take the $8,000 credit on your 2009 tax return. Like, seriously, this is what my 2009 tax form looked like:
So, we’re going to say that I made an initial equity investment on this property of $6,000. The reality is that I was subsidized with other people’s money for the rest of that down payment. Certainly many thanks are in order to my parents for offering over three decades of emotional and financial support (and also for not freaking out when I tell them I’m going to adios gainful employment and travel for a while.) But I also don’t want to overlook my fellow taxpayers who hooked me up with a solid slice of free equity during a time when I didn’t even know what an IRA was.
What Was My Return on Investment ?
To calculate my precise return on investment would be a rather arduous process. I’m not even sure that I still have all the data to be honest. But to summarize the types of data that this would require:
|Repairs||Federal Tax Credit For Purchase|
|New Appliances||Parental Down Payment Gift|
|Homeowner's Warranty Policy||Federal Tax Credit for Energy Efficiency (Dual Pane Windows & Doors)|
|Home Inspection||County: Homeowner Exemption Reduction on Property Taxes (personal residence period only)|
|HOA Fees (Monthly, and Purchase/Sale Related)||Personal Residence Capital Gain Exclusion - Federal|
|Closing Costs (Purchase & Sale)||Personal Residence Capital Gain Exclusion - California|
|Mortgage Interest||Tax Deduction for Mortgage Interest|
|Property Tax||Tax Deduction for Property Taxes|
|Capital Improvements||Rental Income for roughly 2 years.|
|Depreciation Recapture||Depreciation Tax Deduction|
|Utilities||Reduced housing costs vs. equivalent rent in the area for 3.5 years|
|Management Fees for Rental Period||Tax Deduction for HOA, mileage to board meetings, tax prep etc while used as Rental|
It doesn’t matter because Return On Equity is the Proper Metric.
One of my favorite Bogleheads Forum posters is Elizabeth aka meg77 on the forums. She’s a mortgage banker in Texas and she always gives informed advice to Bogleheads who ask questions on the forum. I’ve stopped giving advice at that place because I’m really no expert at all. People like Elizabeth are the true money experts. Because, you know, they actually studied money, they actually get paid to talk about money, and they’ve probably experienced a lot of different money situations along the way. Me? I’m a dude who has had one money story, a few stubborn opinions and a better-than-average sized investment account. I’m happy to share my opinion, but I feel lukewarm about individually giving folks specific money recommendations at this point in my life.
Elizabeth has a real estate empire of her own. She pointed out to me in a recent conversation in the comment section of her blog that when it comes to real estate, ROE is the most practical metric for analyzing a real estate investment. This is because ROE takes into account the equity that you are accumulating by using leverage to finance your investment and pay down the mortgage balance over time. By the way, in late 2011, I refinanced from a 30 year loan to a 15 year loan at a much lower interest rate which drastically lowered my financing costs for the majority of my time of ownership. Did that make my ROE higher or lower if I were to maintain the higher financing costs? You’re asking the wrong guy! I don’t have a clue! Someone else can do that math.
ROE is going to be the tool that you use to calculate the change in your net worth as a result of owning real estate. And when you don’t owe income taxes on the property gains, it’ a pretty simple calculation.
Net Proceeds From Sale
While I did sell the property to a cash buyer for $210k, there was no $200,000 wire transfer sent me way. I still had an $85,000 mortgage at the time. I started out with a $108,000 mortgage. That means over the course of 5.5 years, I paid down $23,000 in principal. Does that mean that having a mortgage during a rising real estate market is almost like a super secret savings account? I also had all of my closing costs. The escrow company distributed all those funds to the various parties prior to sending me a still pretty huge wire transfer.
My net proceeds after closing was, as mentioned before, right around $111,000.
What did I do to celebrate? Well, the first thing I did was pay off the small four figure balance that was left on my auto loan. Then, I invested the rest in equities. After that, I went to work the next day. So money stuff happened and life went on like normal. As it probably should.
I even continued to side hustle in the form of chasing credit card and bank bonuses. I continued to save a hefty portion of my work and side income. Compounded growth compounds more when you save more and add to it.
What was my Return On Equity ?
Over the course of five years, that $6,000 of my initial investment turned into $111,000. That’s $105,000 of growth. Or an average of $21,000 per year. That’s an ROE Of 350% PER YEAR or an ROE of 1,750% over the life of that initial investment. That is an investment outcome that I don’t expect will ever be duplicated in any future 5 year period of my life.
I’m definitely not suggesting that we confuse outcome with strategy here. But to me, it seems pretty damn intuitive that if somebody paid more than double what you can pay for a capital asset that you also get to live in for less than the equivalent cost to rent somewhere else, the odds are pretty low that it doesn’t end in your favor. And if it goes up, it’s not taxable to you. And even if it does go down…your downside risk is astronomically smaller than whatever the last owner’s downside risk was. But lived-in real estate is always bad for millennials. Index funds are always good. Maybe rental properties are okay. Because some popular internet personalities have that opinion.
My Own Influence On All of This.
There were clearly a lot of external factors at play here. I’m skeptical that I will ever experience a more passive form of income than “live in condo because it’s cheaper than renting, it shoots up in value, sell it for huge equity gain”.
That being said, I obviously played a role here too. I didn’t use real estate growth as an excuse to stop saving in retirement accounts or taxable brokerage accounts. Those choices have given me much more of a buffer when we’re talking about taking some time away from gainful employment.
I also obviously had the foresight to recognize that I was sitting on all this equity and I pulled the trigger to re-deploy it into what I consider to be far more productive assets. Not everyone would make that choice. In a recent podcast, the Mad Fientist stated that people who see growth in home equity will probably just buy another house and try to duplicate the results. Am I really the exception ?
What if…? Who cares…?
If we play the what if game….what if I had bought something more expensive ? What if I had taken on more leverage? I very well could have seen greater financial success. But if I had made that choice, I might not have had as much ongoing free cash flow. Maybe I would not have been able to spend six weeks in Australia/New Zealand back in 2012. Or three weeks in Europe in 2014.
Or spending a year paying a measly $1,000 per month to live in a townhouse that was walkable to a beautiful California harbor. A townhouse that somebody else paid $625,000 to own. (Identical property in complex currently listed for $580k, but California real estate always goes up, right?) The growth from my property was more than I ever could have expected or hoped for. The outcome is something that will have a long-lasting effect on my personal financial life forever. That absolutely has to be good enough. The “what if?” just doesn’t matter.
Conclusion: Good Debt Does Not Exist … Unless It Works Out In Your Favor?
My friend Alyssa recently wrote a great post opining that good debt does not exist. When I look at my financial stats from before and after taking on debt, it’s easy to subjectively feel like those debts were good debts. However, I think we can objectively conclude that what actually happened is that my debts worked out. Financing both of those items catapulted me into a very different financial position today. But could I have known that in advance? No. Was it a reasonable educated guess? Probably. Though I certainly didn’t have the financial acumen to know that at the time.
Is it really fair of me to hop on the “no debt is good” and “lived-in real estate is foolish” bandwagons? That combination is literally what made me 6 figures richer in half a decade!
Real estate is by no means automatic. Leverage does NOT always work. My friend Miss Mazuma has chronicled her own misadventures which produced entirely different results than my own dabble in the real estate world. Was I a genius real estate investor and Miss Mazuma an incompetent real estate investor ? Definitely not. Miss Mazuma knows far more about real estate investing than I ever care to know. The reality is that I had an unbelievable momentum of good luck on my side. Whereas Miss Mazuma unexpectedly had a massive freight train headed in her direction.
In the blogosphere, I feel like there are camps of two extremes when it comes to real estate. The anti-real estate crowd and the real estate tycoon crowd. Is there really no middle ground? Or is the middle ground just too boring for someone to want to read about ?
However, since I am the person who happened to be lucky enough to have all of these things go right all at the same time. And, because I write about money on the internet, I might as well throw this uncomfortable fact out there:
I was essentially launched on a high speed rocket ship towards financial independence.
Entirely because of my proper and lucky use of leverage and subsidies. My sister is a few years younger than me. My cousin is a few years older than me. Both grew up comfortably with parents who gave them fantastic childhoods. Both had a boost into adulthood in the form of a free college education. Neither had a once in a lifetime real estate opportunity that I apparently had. Neither had $8k offered to them from the federal government to purchase real estate. Because…Luck. Because…Circumstances.
That’s important to recognize because I can be good with money until the cows stop mooing, but there’s no mathematical way that I could have frugal saved or index fund invested my way to my current net worth in the timeline that I have done it in.