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More Windfall Choices

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THE SCENARIO Last time, we looked at a choice between investing in the S&P 500 versus buying a rental house after receiving a windfall of $200,000. I've gotten feedback that the results were surprising, as lots of people favor rental real estate over stock market investing. I understand that feedback, but if we look at why the results came out that way, it's easy to see that we didn't do a great job buying a good rental house - there are certainly far better options out there. So let's look at the same scenario again, and this time we'll be a bit more judicious with the property we buy. Instead of buying one $200,000 rental house free-and-clear which only nets $400 per month in rent (which is quite a low amount for a free-and-clear house in that price range), let's think about using leverage to get more out of our windfall by buying multiple different properties, and using bank financing to purchase them. Banks often like to see at least a 20% down payment when financing rental property, and we'll make them even more comfortable with 25% down on each of 4 properties. Each of these properties will be the same: $200,000 cost with 25% down, gross rent of $2,000 per month and 45% net expenses before debt service. We'll use the combined net rents from all four of these houses to buy S&P 500 index funds, just like we did in last week's post. The index funds will appreciate at 7.5% per year. We'll get the same kind of loan for all four of these houses: 25-year fully amortizing loans at 6.125%. The houses, like the one in last week's post, will appreciate at a 3% annual rate. The question: If I sell everything at the end and combine the money, how much will I have in 25 years?

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THE SOLUTION This one has several parts:

1. Find the net rent per house before debt service
2. Find the payment on each loan
3. Find how much I'm investing in stocks each month
4. Find the value of the stock portfolio after 25 years
5. Find the total value of the houses after 25 years
6. Find the total value of my windfall after 25 years

First things first, make sure the calculator is using 12 Payments per Year. Step 1: Find net rent Each house has gross rent of $2,000 per month, and 45% of that goes to expenses. That leaves me with 55% of $2,000, which is $2,000 x 55% = $1,100. Step 2: Find loan payments Each house is worth $200,000, and I'm putting down 25%. This means that I'm borrowing the other 75%, or $200,000 x 75% = $150,000. N: 300 (The loans are 25-year loans, which is 25 x 12 = 300 months) I/YR: 6.125 (The loans have an interest rate of 6.125%) PV: 150,000 (The initial balance on each loan is $150,000) PMT: (This is what I'm trying to find) FV: 0 (The loans amortize fully)

The payment on each loan is $977.95 per month.

Step 3: Find monthly stock investment Each house makes $1,100 before making the loan payment, which is $977.95. This leaves $1,100 - $977.95 per house, per month left over to buy stocks with. $1,100 - $977.95 = $122.05. Since there are four houses, the total I'm putting into the S&P each month is $122.05 x 4 = $488.20. Step 4: Portfolio value N: 300 (I'm investing in the S&P 500 for 25 years, which is 25 x 12 = 300 months) I/YR: 7.5 (The index is assumed to increase in value by 7.5% per year) PV: 0 (When I start, I don't have any money in it) PMT: -488.20 (Each month, I invest $488.20) FV: (This is what I'm trying to find)

After 25 years, my stock portfolio is worth $428,292.98.

Step 5: Total house value N: 300 (The houses appreciate for 25 years, which is 25 x 12 = 300 months) I/YR: 3 (The houses appreciate 3% per year) PV: 200,000 (At the beginning, each house is worth $200,000) PMT: 0 (No money flows in or out of the value of the houses each month) FV: (This is what I'm trying to find) After 25 years, each house is worth $423,003.91. Since the loans are fully amortizing and have terms of 25 years, they're completely paid off at this point.

All four houses together, then, are worth $423,003.91 x 4 = $1,692,015.65

Step 6: Overall total value After 25 years, the stock portfolio is worth $428,292.98 and the houses are worth $1,692,015.65, for a total of $428,292.98 + $1,692,015.65 = $2,120,308.63. As we found in last week's post, the total value of the windfall when invested solely in the S&P 500 for 25 years was $1,296,576.09. Using the blended approach with leverage nets us $2,120,308.63 - $1,296,576.09 = $823,732.54 more than the stock index alone.

What do you think? Is this result more in line with your expectations? Did I miss anything, or use unrealistic assumptions? Let us know in the comments!