Expert: Matt Heisler - 2/25/2008

Question
My husband and I own a three-unit house.  We live in one of the units and do all the work ourselves.  We are not sure what to do next.  We could get other investment properties.  We really don't mind the work.  But we are wondering how much more we would make if we keep the properties for 30 years until we retire vs. putting the money on our 401(K)s at a return of 8% in index funds.
Thanks,

Answer
I can't answer your question specifically; there are too many variables. But here is how you would figure it out.
1) Sell the property, put gains in 401 K.  Take your profit, x * 1.08 ^ Y, where is the number of years that you're compounding it.

The house requires more calculations:
1) Cash after expenses.  Recognize that rents will improve over time, by about 3% (to be conservative) annually.  Assuming you have a fixed payment, each year the building will throw off more cash.  But what do you DO with this cash?  If you put it in a similar index fund, you'll return more money.
2) Then there's the house - the house itself will return between 3-5% a year, but your rate of return varies with the leverage that you have on the house, and that varies with how much of your mortgage is paid off. So if the property is worth 100K, with an 80K mortgage, the first year you make $4000 in property increase valuations, and your rate of return is a whopping 20%.  In the last year, however, the property is worth about 250K, but you now have the full amount of capital in the building, so your return is just the 4%.  

I did a simple calculation (and others besides) and for a 100K building, with an 80K mortgage, that starts off with $500K/month put in an index fund making 8% for 25 years, You'd make $332,000 in rent, and the building would be worth $230.  You paid 20K for it, for a $210K return.

So that calculation makes it look like cash is king.  But the secret to the sauce is LEVERAGE. If you buy multiple investment properties,  and keep them leveraged at about 3 or 4 to 1, you'll make a lot more money in the long run, using a minimal amount of invested capital. The trick is not to get overleveraged - you want to make sure you have enough cash coming in to cover all expenses, and have cash on hand for emergencies.

Matt Heisler