News

Debunking the Idea of an Infinite Return

I’m a fan of real estate investing. If you would like to learn how to get your first rental property, check out our current promotion from our partners at SemiRetiredMD—their Zero to Freedom Online Course. If you buy through that link during the wait list sale, you get $300 off, get our WCICON-Park City online course, and a signed copy of my Financial Boot Camp book thrown in for free.

However, one of the things I hate about real estate investing is all of the scammy marketing surrounding it and its “Rah-rah, you can do it!” mentality. It reminds me a little of multi-level marketing that way. The only reason you need to be motivated to do something is because it actually takes a lot of hard work to do it! At any rate, a great example of a scammy marketing term is the phrase “Infinite Return.”

Getting an Infinite Return by Refinancing

The phrase “Infinite Return” is generally used in one of two ways. The first is almost completely bunk. Here is the way it works.

You buy a property with a down payment. Let’s say it’s a $400K property, and you put down $100K. Over a few years it appreciates, and you pay down the mortgage a bit. Now the loan to value is low enough that you can actually refinance it and pull some money out of the property, maybe even an amount of money equivalent to your original investment. It even comes out tax-free, since it is not income nor capital gains. You can then take that money and spend it or use it to buy another property. This can be a pretty savvy move. What it does not do, however, is provide you an infinite return on the property. But that is what those using this term would have you believe. They’re saying because you got your original $100K back that the property somehow did not cost you anything and that you should only calculate your return going forward from that point. Which is obviously a bunch of bunk. I mean, let’s run the numbers and see what your return is on the property.

A reliable way to calculate a total return is the XIRR function. We’ll make up a few numbers for this investment. You put $100K down on a $400K property. 3 years later the property is worth $500K and you have a $275K mortgage. You then pull $100K out of the property. Here is what it looks like in Excel:

Now don’t get me wrong, 31% is a very good return. But it is not an infinite return. But what about going forward? Well, let’s start from where we are at and look at a few more years.

Right now you have an investment of $125K, $500K in property value minus a $375K mortgage. Let’s say a few more years go by. You pay the mortgage down to $350K and the property appreciates to $600K. What’s your return? (For simplicity’s sake, let’s again assume that all income from the property went toward property expenses or that mortgage).

Again, 26% is a very good return. But it is not an infinite return. The only way that could be an infinite return is if you could borrow 100% of the value of the property back out of it. Then it would look like this:

infinite return

That would be an infinite return. But no lender in their right mind would lend 100% of the true value of a property. Even if they were in first lien position and could foreclose, they’re still going to come out way behind by the time all of the costs of foreclosure are paid.

You could do the same thing with a mutual fund, right? Imagine you bought a mutual fund for $100,000 at $50/share. If the share price goes up to $100/share, you now have $200,000. If you sold half of those shares, you would walk away with $100,000 in cash (at least, pre-tax) and $100,000 worth of shares. But you wouldn’t then start saying “I’m getting an infinite return on my investment” because that would be stupid. It’s like the people who say “I’m now just playing with house money.” No, you’re not. It’s your money; it stopped being the house’s money when you won it from “the house.”

Cash on Cash Returns 

So if these “Infinite Return” folks are not talking about total return, what are they talking about? Well, they could be talking about a “cash on cash” return.

Cash on cash return is a bit of an artificial type of return that real estate investors sometimes use, sometimes to try to impress other people (whose money they are trying to obtain.) However, it is mostly used because it is far easier to calculate than the more useful total return. How do you calculate it? Let’s say an investor puts $100K into a syndicated deal. She is then sent a check at the end of the year for $6,000, her share of the cash flow for that year. You would then say her “cash on cash return” is 6%, $6,000/$100,000. Kind of an interesting number, but it doesn’t really say much at all about her total return. In order to know that, you would have to know how much of the mortgage was paid down and how much the property value changed. But it is a number you can rapidly calculate and that does not require the property to be appraised, much less sold, to determine its value.

The funniness comes in when they start calculating her “cash on cash return” for the subsequent years. Let’s say the next year she gets $7,000 and the following year $9,000. Now her cash on cash return is up to 7% and 9% because it is based on the original cash she put in, which is related to the original value of the property, not the current value of the property. The property is probably still just paying out 6% of its value as income. That hasn’t really changed. It gets really funny after a decade or two. Now maybe it has an annual cash on cash return of 20-30%! What a great investment! No, it’s still the same old property earning about the same return it has been earning all along.

So if you want to just look at a cash on cash return, then, sure, you can get an infinite return once you pull that original cash out and only look at the cash on cash return going forward from that point. The cash on cash return is not really the best measure of your overall return, but the real estate gurus NEVER say “Infinite Cash on Cash Return,” they just say “Infinite Return”, leaving the mark unsophisticated potential investor to figure it out.

Getting an Infinite Return by Putting Nothing Down

The second way a real estate investor gets an “infinite return” is by putting nothing down. Since nothing went into the property, if it earns any sort of positive return, that is technically an infinite return. In order to address the fallacies associated with this idea, one must take a deep dive into the “nothing down” philosophy.

As a general rule, a property is not cash-flow positive until there is a loan to value ratio of 0.75-0.67. That is to say, if you do not want to be feeding a property every month by putting money into it, you should plan to put down 25-33% on it. If you put down less, the costs of the property, including a much larger mortgage, are now more than the income the property produces. So now you not only have a negative cash on cash return, but you have an INFINITELY NEGATIVE cash on cash return. That doesn’t necessarily say anything about your total return, but it will not be infinite if you put one dime of money into the property at the time of purchase or afterward.

infinite return

If you want to avoid a down payment AND have a cash flow positive property, you will likely do one of several things (and these are the same “nothing down” techniques taught to you for thousands of dollars at seminars. You can have them today for free. You’re welcome.)

  1. Steal the property. Not legally speaking, but essentially you need to find someone so desperate to sell that you are creating equity when you buy by purchasing the property for 25-33% less than it is actually worth. Don’t get me wrong. This is entirely possible. There are a lot of desperate people out there who need to move right now for whatever reason (often because the bank is about to foreclose). These are the people the folks who put those signs along the roads in your town “We Buy Houses for Cash” are looking for. In this situation, you’ve essentially bought a $150K property for $100K. And you got that $100K from someone else. Maybe an investor or a hard money lender. Doesn’t matter. But it wasn’t yours. However, the second you buy the property you know what IS yours? That $50K that you created (? stole) by purchasing the house for less than it was worth. So going forward, your total return will not be infinite (because you have $50K in it that can be accessed at any time by selling the property.) But your cash on cash return will be infinite.
  2. Rapidly improve the property. Similarly, if you can rapidly improve a property such that its value is higher, you have essentially created equity out of thin air. An example might be turning a 2 bedroom home with a goofy unfinished basement into a 4 bedroom home just by putting in a couple of cheap walls. Now all of a sudden a home that was worth $200K may be worth $260K. So maybe now you can pull $80K out of it and have an infinite cash on cash return going forward from this point. But your overall total return on the investment is not infinite, because you put something down in the beginning. I’m not saying it isn’t a good investment. It is. But its total return is not infinite.
  3. Get the seller to provide the mortgage. Sometimes a seller is willing to take back a 100% mortgage. What would entice a seller to do so? Usually one of two things–either he gets a higher price on the property or he gets an above market rate mortgage on a property. Or maybe he’s just dumb. Or desperate. Either way, you have put nothing into the property. However, the likelihood of that being a cash flow positive property at this point is pretty low. So you’re likely to have an infinitely negative cash on cash return and a less than infinite total return.
  4. Assume the existing mortgage. Sometimes a seller needs out of the house so badly that they’ll just give it to you if you take over the mortgage. Now that needs to be okayed by the lender, but this does happen from time to time. However, the same issue applies. Either you “stole” the property for much less than it was worth, or it is unlikely to be cash flow positive.
  5. Swap personal property. Maybe you can trade your motorcycle for a down payment. Obviously that motorcycle has value. So while this might be “no cash down”, it is not “nothing down.” When calculating a total return, you would need to include the value of the motorcycle.
  6. Swap personal services. Maybe you offer to work on another property this person has in exchange for a down payment. However, your time has value and should be included when calculating your return.
  7. Sweat equity. You put a ton of work into the house, fixing it up such that it becomes cash flow positive despite putting little down. While your cash on cash return may be infinite, your total return is not because your time has value and that should be included in the calculation.
  8. Get a partner. Sometimes you can take on an investor who provides the down payment if you do the work. Same issue–your time has value so your total return is not infinite, even if your personal cash on cash return is. At any rate, we used to call this thing a job, not an investment.

  9. Turn your house into a rental. This does not require cash, but it does require the contribution of something valuable–your home equity. Any realistic total return calculation should include that value.
  10. Combine mortgages. This sounds like “nothing down” but in reality, you’re simply taking equity from your other property and using it for a down payment. That would need to be included in a total return calculation.
  11. Take on the seller’s debts. A seller might waive a down payment in exchange for you paying their other debts (in addition to paying a mortgage on this property). However, those cash flows need to be counted when doing a total return calculation. The property is now almost surely cash flow negative and will have an infinitely negative cash on cash return and a less than infinite total return.

As you can see, there are a lot of creative ways to purchase a property without cash. However, most of these do not provide an infinite cash on cash return and none of them provide an infinite total return. When you start hearing people trying to sell you the idea of an “infinite return”, put your hand on your wallet, proceed with caution, and make sure you know what kind of return they’re really talking about!

What do you think? Is it fair to say a real estate investment has an “infinite return”? Why or why not? Have you bought a property without cash? How did you do it? Comment below!

 

The post Debunking the Idea of an Infinite Return appeared first on The White Coat Investor – Investing & Personal Finance for Doctors.

What's your reaction?

Excited
0
Happy
0
In Love
0
Not Sure
0
Silly
0

You may also like

Leave a reply

Your email address will not be published. Required fields are marked *

More in:News

News

VTSAX vs VTI

By Dr. James M. Dahle, Emergency Physician, WCI Founder   Q. Is it better to ...