The Anatomy Of A Home Run Real Estate Investment

Home run real estate investment

They say good things come to those who wait.

Well, my wife and I certainly had to wait to make our first commercial real estate investment.

We originally started looking for our next property in January 2019.

Having screened tens of properties, we made a handful of offers but just couldn’t get a deal over the line.

The opportunity cost of sitting on a pile of cash in 2019, when the stock market went up 30%, was astounding.

It’s not something that gets a lot of airtime, but real estate investing comes with its own challenges – and this was certainly one of them.

Thankfully, we finally managed to get a deal done at the height of the pandemic.

Last month, it was time to file our first tax return, which also gave us a first look at the performance of the investment so far.

Let’s start off with…

The Juicy Details

The total cash flow (after mortgage payments) came to around $10k.

Given we’ve only owned the property for six months, that works out to about $1,700/month.

Thus, on a calendar year basis, the property spins off $20k of cash, representing a nice 7% cash yield on our original equity investment of $280k.

In addition, there’s about $18k of mortgage principal that gets repaid every single year, bringing the return to $38k or 13.6%.

Most importantly, there’s price appreciation.

Clearly, the real estate market has been on fire over the past year.

We bought the place for $855k and I see comparable properties trading for $1.2m now, so we are also potentially sitting on a $350k price gain.

However, let’s ignore the noise and assume the property appreciates by just 3% a year, in line with long-term inflation.

Assuming it’s worth $1m today, that’s $30k of price gains a year.

All in, that brings total annual returns to $68k – or about 24% of our initial $280k investment.

That makes it hands down our best property investment to date.

Over time, I expect the $68k to grow materially as rents go up, mortgage paydown accelerates, and price growth compounds.

Below, let’s do a little tear-down on what has gone well, what hasn’t – and what’s in store for the future.

What Went Well?

Residential Vacancy

While we priced in about 4% vacancy, we had zero vacancy last year.

Clearly, this will change over time.

However, I’d be quite happy to have some tenant churn given three out of four apartments are currently rented below market price (more on this below).

Commercial Vacancy

The commercial unit is occupied by a restaurant.

Now, I fully expected the owner to try and negotiate a rent holiday with me, especially given what was going on last year.

However, being an experienced restaurateur, he kept the place going and made his rent payments on time.

He did renege on about $1.5k of expense reimbursements, which I have banked as a receivable going forward.

More importantly, the commercial unit is rented at $2k a month, which is roughly half the market rate.

The commercial lease is up next year, and I strongly suspect the owner is trying to build some goodwill to try to keep the rent hike at a reasonable level.

Taxes

This is a big one.

Working with our accountant, we were able to claim a number of allowable deductions, which reduced our tax rate in a meaningful way.

Many of these serve to defer taxes into the future and will be reclaimed by the tax authorities upon sale of the property.

However, I don’t intend to sell the property for a very long time – and thus the time value of money makes tax deferral a very effective strategy.

Learning about taxes is as unexciting as it gets. But you can trust this certified accountant when I say it happens to be a highly effective way to get rich.

Buying At The Bottom

This is by far the biggest factor that played to our advantage.

Not many people were shopping for commercial real estate in April 2020, which is when we were negotiating our deal.

As such, we’ve managed to secure a $55k price reduction – and got to ride the roaring recovery afterwards.

In addition, our property benefited from the flight out of big, unaffordable cities over the past year.

It’s located in a satellite town just 2 hours away from one of the largest cities in North America.

Thus, it is benefitting from a significant population increase, which is reducing vacancies and increasing property prices.

So far, so good. But to say it was all smooth sailing would be a lie.

What Could Have Gone Better?

Property Tax and Insurance

Compared to our projections, property tax came in $3k higher than expected.

Ditto for insurance, which came in $1k above estimates.

This is why it is critical to include a solid contingency buffer in your numbers. Things can and will go wrong.

Thankfully, we had about $5k baked in for any unexpected expenses, which comfortably covered the items above.

Bad Debts

Our commercial tenant hasn’t reimbursed us for about $1.5k of TMI (taxes, maintenance, insurance) that related to his unit.

In a different environment, I would have served him with an eviction notice right away.

However, the last thing I’d like to do right now is to have a vacant restaurant unit. Yes, the economy is finally picking up steam.

However, I’d much rather have a proper renegotiation of the lease later this year. I expect the consumer sentiment to be firing on all cylinders by then, giving me a much stronger hand.

Property Management

In the imaginary world of “passive” real estate investing, you hand off the keys to the property management and just bank the cash, right?

Perhaps, though I am still waiting for that nirvana-like experience!

To be fair, our property managers are pretty good – I’d give them a solid B+.

Still, we’ve had a few bumps in the road that needed to be resolved. Things are much smoother now but I’d say we spend at least a few hours a month checking in on them.

In other words, you’ve got to “manage the manager” – because they certainly aren’t going to manage themselves!

What’s Next?

To be honest, this is probably the most exciting piece of property in our entire portfolio right now.

For starters, three of the four residential units are rented at well below market rates. Altogether, there’s about $750 of rent upside per month – or about $9k a year.

Now, I cannot (and would not want to) kick my tenants out under some false pretense.  I also cannot unilaterally raise rents by more than inflation.

However, tenants always churn over time. Every single time there’s a vacancy, I will be able to do a few cosmetic renovations to the unit and realize a significant rent upside.

Then there’s the commercial unit, which is rented for $2k a month while the market price is around $4k.

Our lease is up next March, which means we will renegotiate towards the back end of this year.

Will I be able to get him to pay market rents overnight? Most likely not.

I do, however, expect to put in place rent escalators every year to bring the rents in line with the market over the next 24 months or so.

That’s another $24k of annual rent upside.

Thus, by “repricing” the rents, I will essentially increase the net operating income of the property by $33k.

At a 6% cap rate, that’s about $550k of value creation, which should take the price of the property to about $1.65m by 2023.

By that point in time, we will have about $550k left on the mortgage, implying an equity value of about $1.1m.

That’s a 4x increase compared to the $280k we’ve put in last year – and this is before you factor in the ongoing annual cash flows of $20k+ along the way.

Is this as good, easy, and quick as becoming an overnight Dogecoin millionaire? Not by a stretch.

Then again, this is not how people get rich with real estate. Property investing is a long-term game.

And somehow, I’ve got a good feeling about it.

Thank you for reading – and happy (real estate) investing!

P.S: if you are interested in real estate investing, make sure to check out my previous posts on the topic.

You may also want to check out Frank Gallinelli’s fantastic book on the subject (you can read my review here – scroll down to “Real Estate”)

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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker.  I am passionate about capital markets, behavioural economics, financial independence and living the best life possible.

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12 Comments

  1. Sounds like a cracking investment BoF.

    I’ve only done residential myself (built one house to try my hand in earning a developer margin, have two rentals and own my current residential). This is definitely inspiration to look into mixed residential / commercial!

    In the mean time will continue slogging in banking…

    • Thanks KoF! Yes, we are pleased, though it did take us 18 months to source and close this deal

      Hadn’t realized you are also in banking – very impressive property portfolio alongside a busy job. Nicely done.

      How did you find the residential build? I’d like to try this at some point (one bucket list item is to design and build my own house) but wouldn’t dream of it alongside my current job.

      I don’t do usually offer guest posts on this blog but would love to make an exception for you if you were minded to share your experience 🙂

      • It was not a bad experience and would do it again though probably as a build to let as a longer term yield play if I were to do it again.

        Was lucky to fall into a plot of land that was ready to build at an ok price from a family friend and kept it simple with a good project manager. Was a 10pc unlevered IRR event and mainly involved a lot of after work payment of invoices as I’d selected a design that the PM had built to before with subcontractors he’d previously work with. Think key for me was just making sure I was ok on the downside of not selling (ie. renting to a tenant as a fall back) and being able to let the PM do his thing.

        On guest writing perhaps one day! I am impressed how you have the energy to be so consistent on blogging and think it is great what you are doing with sharing your journey out there.

        • Nice one, very impressed you managed that alongside your day job!

          And totally get it re: downside protection. Nothing quite as liberating as knowing you’ve got a fallback plan and won’t lose money.

  2. Great insights once again Damian – thanks 😀.

    Is there any truth that entering BTL in the UK now is simply not cost efficient due to ever growing tax implications?

    Does setting up a company and buying property for BTL that way improve the situation?

    As ever, thanks for another great article (but no ‘like’ button yet!).

    Kind regards,

    David

    • Thanks David!

      For full disclosure, I don’t own any property here in the UK (including our primary residence which we rent) so I don’t want to get ahead of my skis.

      The reader comments on this post were pretty insightful – from folks who actually do BTL in the UK:

      https://bankeronfire.com/how-people-get-rich-with-real-estate

      What it fundamentally boils down to is finding a property with a high enough yield that will offset the incremental cost and hassle of being a landlord here in the UK.

      Broad sentiment is that it’s getting harder and harder as yields have stayed flat (or come down) while cost and hassle went up!

      And yes, the like button is still on my ever-growing to-do list 🙂

  3. Interesting article as usual. I have recently read the book by Chris Voss “Never split the difference” Chris Voss is an ex-FBI agent and negoiater(SP!). In out lives we all have to negotiate for pay raise, buying property and the renter wants to pay as little as possible. Do you set a price and stick to it as in maximum or minimal price. You set the price and know the price before entering a negotiation? Do you bater?

    regards,

    Cleophas

    • I LOVE negotiating and cutting deals. I enjoy both the process and the ability to create value by coming up with win-win constructs.

      However, that’s more in my professional life – whether negotiating deals for clients or employment conditions (including pay) for myself.

      The property market is slightly different – more about not paying significantly more than competing bidders and getting the highest-quality tenants at market rates.

  4. It truly is nuts how well real estate is doing. I’m very thankful to all the sellers out there.

    Without real estate, I’m not sure I would have left banking early. Real estate accounts for about $150K of our annual passive income and should increase over time.

    Let’s go RE bull market!

    Sam

    • I’m happy for the property market to stagnate, or even decline in value – as long as rents stay flat.

      Will allow me to buy more properties before prices increase even more!

  5. Incredible. Love that your commercial tennant was able to keep things going without any issues. Seems like you guys really banked in at the right time and the yields seem great for a real estate investment. I was searching in the fall in our area and I could not find anything that compared with these types of numbers. Great job!

    • Thank you!

      Yeah, this one looks quite promising so far, though in reality real estate investments are proven out over years and decades, not mere months.

      We did spend 18 months looking for it, and had to properly gird our loins when signing the deal in April 2020!

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