A Case Study: Buying 1 Bellingham Rental for Cash vs. 4 Rentals with Mortgages

Bob and Jane are twins.

From birth, they’ve been best friends.

And yet they are highly competitive with each other.

At 50 years old, they each inherited $600,000.

They’d both been reading and learning about investing, so they decided to invest their newly-acquired money in real estate.

Specifically, Bellingham rental properties.

But Bob and Jane, despite being twins, had very different outlooks on investing.

Bob Hates Debt. Jane Loves Leverage.

Bob believes: “If you can’t pay cash for it, you shouldn’t buy it!”

This has served Bob well over the years, as Bob has no debt whatsoever.

Jane, however, believes: “With today’s low interest rates, why use all my own money when I can use mostly the bank’s?”

So with their different attitudes, they went out into the market and began looking for some candidate properties.

A developer had just finished a row of brand new, nearly identical, single family homes.

Two thousand square feet, 4 bedrooms, 2 1/2 baths, 2-car attached garage, a fenced yard with room for a garden!

The rental market was strong, and a house like any of these would fetch $2800/month in rent, or $33,600/year.

Bob and Jane also loved that with single family homes, it’s customary for the tenant to pay all utility bills, and also maintain the landscaping.

Operating Expenses

The property taxes for each house were $5000/year.

Insurance was $1000/year.

Bob and Jane also budgeted $100/month for miscellaneous maintenance.

They would manage the rentals themselves, so they didn’t budget anything for a professional property manager.

Bob and Jane had learned that, collectively, this $7200/year expense was known as the “operating expenses.”

Bob and Jane Are Excited

Bob said to Jane, “This is serendipity. We have exactly the right amount of cash to each buy one house.”

Bob called his Realtor, wrote up a full-price cash offer, and got one of the houses under contract that very night.

His dreams of owning a clean, well-built, brand new rental were coming true.

Meanwhile, Jane slept on it, and the next morning she met with her lender.

She wanted to explore the idea of getting a 30-year fixed mortgage.

Her lender explained that if she used 1/4 of her $600K, or $150,000, as a down payment, she could finance the rest.

The interest rate on the loan would be 3.75%.

There would be about $3500 in closing fees, but Jane was comfortable with that. She had some money in savings, too.

Her monthly principle and interest payment on that $450,000 loan would be $2,084.

In addition to the monthly operating expenses, the monthly payment became $2,684 — nearly equal to her monthly rent of $2800.

But in Jane’s mind, she would still be “cash-flow positive”.

And she would only be using 1/4 of her inheritance to buy one house.

Jane looked across the desk at her lender with a clever smile.

“Can I put that same one-hundred-fifty-thousand dollar down payment on three more houses, and buy four of them?” she  asked.

Her lender smiled cleverly back at her. “Why yes, Jane… yes you can.”

Jane then called her Realtor, and that day they wrote full-price *financed* offers on 4 of the brand new houses.

Like her brother Bob, her dreams of becoming a real estate investor were well underway.

Bob & Jane Discuss Their Plan

The next morning, Bob and Jane got together for breakfast to talk about their plans.

They agreed they would hold the properties for 10 years, and sell them when they turned 60.

Jane shared her mortgage strategy with Bob, and how she would leverage her $600K to buy not one, but four houses.

Bob snickered, “You’ll be in debt! And with your mortgage payments, you’ll have almost no cashflow whatsoever.”

“That may be,” Jane replied. “That may be.”

The Siblings Create a “Pro Forma”

The siblings spent the next hour analyzing market data their Realtors had given them.

The Bellingham market had, in recent years, experienced *very* strong appreciation, as much as 20% in a single year!

But Bob and Jane knew that, over 10 years, there would be slow-downs and market corrections, just like they’d seen during the “Great Recession.”

So to be cautious, they factored for the 18-year average Bellingham appreciation of about 6.5%.

They knew their operating expenses would increase, so they factored annual 3% increases.

They also planned to increase the rents by 3% each year.

These may be low assumptions, they agreed, but they were consistent.

They raised their glasses in a toast, “To our next ten years as real estate investors!”

And so their journey began.

A Meeting at the End of Year One

As the 1-year anniversary of their becoming real estate investors approached, Bob invited Jane out for a breakfast meeting.

Bob was proud.

All year he had saved his “net operating income”, or what was left of the rent money after he paid the operating expenses.

He reminded Jane that he has no monthly mortgage payment.

Therefore, after deducting the operating expenses from his gross rents, he had a cool $26,400 cold hard cash.

He also noted that, with the estimated 6.5% appreciation, his rental home was now worth $639,000!

Bob glowed.

He said, “Those returns added together equal $65,400. That equates to a 10.9% annual return on my $600K investment.”

Jane nodded.

“How did you do, sister?” Bob asked, just before taking a drink of his orange juice.

“Oh,” said, Jane. “Well, after my mortgage payment and operating expenses, I have $1392 in cash… for the year.”

Bob sprayed his juice across the table.

“That’s… that’s almost nothing,” he laughed.

“True,” said Jane. “But remember, I have 4 of them.”

“Big deal,” said Bob, juice dripping off his chin.

“It still adds up to a whopping $5568 for the year. That’s less than one quarter what I earned!”

“True,” said Jane. “But each of my rentals also went up in value to $639,000. And remember, I have 4 of them.”

They finished their meeting, split the check, and agreed to meet and discuss the numbers again at the end of year 5.

A Meeting at the End of Year Five

5 years in, Bob and Jane met again for breakfast.

They were now half-way through their 10-year planned holding period, and it was time to review the numbers.

“I’ll go first this time,” said Jane.

“Because of our annual 3% increase in rents, my cashflow for this year is $4704 on each house. So, that’s $18,816 across all 4 houses, total.”

“Hmm,” said Bob. “Well that’s not nothing.” He swallowed his orange juice this time.

“Also,” continued Jane, “my year-5 appreciation on each house, which we estimate at 6.5%, was $49,917. And again, I have 4 of them.”

Bob blinked.

Jane continued, “I do have those mortgage payments, yes. But they’re fixed at 3.75% interest, so the principle and interest payments don’t change, and won’t change, for as long as I have the loans.”

Bob’s wheels turned in his head.

“Each year, the principal is paid down more and more, so I’m gaining equity that way as well,” Jane continued.

“This year, year 5, if you add up my cashflow, my principal reduction, and my appreciation, my total return for this 12 months, on each house, is $64,232.”

Bob leaned in, eyebrows raised.

“That’s a 41.85% annual return on my per-house $153,500 initial investment,” said Jane. “And remember, I have 4 of them.”

Bob rubbed his temples.

“So… brother, share your numbers,” said Jane, right before she bit into a croissant.

“Well,” began Bob, regaining some measure of swagger, “first, there’s this!”

He placed a tall stack of cash on the table.

“This is $29,712. That’s my cash-flow for year 5,” he said proudly.

Jane gave a slow clap.

“And,” continued Bob, smugly, “I too enjoyed our estimated 6.5% appreciation, and therefore my home’s value rose by $49,917. That makes my total year-5 return a healthy $79,629.”

Jane nodded her admiration.

Bob smiled and said, “That’s over $15,000 more than your year-5 return, Jane. I’d just like to point that out.”

“True,” agreed Jane. “So, what’s your year-5 total return on your $600K investment?”

Bob did a quick calculation on his phone. “13.27%,” he answered.

“Ahh,” said Jane. “Well done, brother. You can get the check for breakfast this morning. And let’s meet again at the end of year 10.”

A Meeting at the End of Year 10

As the decade-long, planned holding period came to an end, Bob and Jane sat across from each other at the same breakfast bistro.

“Well,” began Bob, “my dear sister Jane, you are sitting with a genuine millionaire!”

“Wow!” said Jane. “Tell me more.”

Bob smiled as he spoke. “Just this year alone, year 10, my cash flow of $34,445 plus my appreciation of $68,387 puts my total annual return at $102,832.”

“Impressive, brother!” said Jane.

Bob beamed.

“That equates to a 17.14% year-10 return on my $600K investment,” he said.

“What’s even more impressive though, Jane, is my total 10-year return.”

“Oooh, tell me!” Jane said, leaning in.

“So,” Bob said, “My total cashflow over this past decade has amounted to $302,636. Of course I’ve had to pay taxes on that, and I’m in the 22% tax bracket. So after taxes I have a solid $236,056 sitting in my savings account.”

Jane silently mouthed the word “Wowww.”

“Plus,” Bob continued, “with the 6.5% year over year appreciation, my house is now worth $1,123,794! And if you recall, I don’t have a mortgage to pay off, so the net value of my investment, including equity and after-tax cash-flow, is…… drumroll please…. $1,359,850.”

“That, my dear sister,” Bob summarized, “is a 126.6% return on my $600K investment.”

“Oh my gosh,” said Jane. “Bob, congratulations! You must be so happy, so proud.”

“I certainly am,” said Bob, leaning back as he crossed his hands behind his head.

“Now…” he said, “let’s have it. Let’s hear how you did, sister.”

Jane’s Use of Leverage

“OK,” said Jane. “Well… as you know, my total cash-flow was nowhere near what yours was, but it wasn’t nothing, either.”

Bob grinned.

“This last year, year-10, I realized cash-flow of $9,437 per house,” Jane began.

“And, of course, I have 4 of them, so all together my year-10 cash-flow amounted to $37,748.”

Bob was surprised that her total annual cash-flow had risen past his.

“Go on,” he said.

“And,” continued Jane, “my annual appreciation of 6.5% is the same as yours, so this year I gained another $68,387 in equity.”

“I also paid down the mortgage another $11,500,” she said. “So if you add together those, plus my cash-flow, my total return for year-10 was $89,414. Remind me, what was your year-10 total return, Bob?”

“Just shy of $103,000,” just before taking a drink of cranberry juice.

“Right,” said Jane. “But remember… I have 4 houses. So all together, my total year-10 return for all 4 houses amounts to $357,656. On my initial $614,000 investment, that equates to a 58.5% year-10 return.”

Bob sprayed his juice across the table.

“Sooo…” stammered Bob, “what does your total return look like, for all 10 years, for all 4 houses?”

“Oh I’m so glad you asked,” said Jane, before slowly adding hot water to her chamomile tea, while letting the silence linger.

Finally, Jane spoke. “My total cash-flow was nowhere near yours, as you know,” she began. “But it wasn’t nothing.”

“Over these past 10 years,” she said, “I’ve collected a total of $210,224 in rents. I too am in the 22% tax bracket, so after taxes that amounts to $163,975.”

“I’ve also used the mortgage interest deduction to offset my income,” Jane continued. “So over the 10 years, while I’ve paid $606,344 in total interest, the write-offs have saved me $133,396 in taxes I haven’t had to pay.”

“Added to my after-tax cash-flow, that equals $297,371.”

Bob gulped. It was meaningfully more than his rent-money savings account had in it, about $236K.

“And, like you,” Jane went on, “I’ve had that nice 6.5% annual appreciation. But as you might remember…”

“I know,” groaned Bob. “I know. You have… not one… but 4… you have 4 houses!”

“Right,” said Jane. “And though I do have remaining mortgage balances to pay off, my equity on each house is $772,288.”

“Totaled up,” she said, “that’s $3,089,152 in equity. Add that to my after-tax cash-flow and tax savings from deducting the mortgage interest, and the grand total is $3,386,523.”

Bob sat motionless. Everything in the room seemed a mile away.

Jane asked, “Remind me, what was your 10-year return again, Bob?”

Bob murmured, “126.6%.”

Jane added, “Right. That’s not bad, brother. Not bad. But with my strategy……”

Jane pitter-pattered her fingers on the edge of the table, mimicking a drumroll.

“My total, 10-year return on my initial investment was………. 464.4%,” she sang.

Bob stared blankly at nothing in particular.

Jane smiled, then leaned in and whispered, “Breakfast, dear brother, is on me.”

The End

PS… I left out another way rentals make  money: cost recovery (aka “depreciation”) for the sake of simplicity. I promise to cover that in a future story.