David Gray Project #2

REAL ESTATE INVESTMENT STRATEGY

Buy a million dollars worth of real estate on borrowed money. Rent it to break even. If the inflation rate is 13%, as it was in 1980 you just made a $130,000. Write off the interest and wait for next year. Remember the borrowed money is not taxable until you sell the real estate.

What if you could see the future? Well you can! If new constructions costs are rising, it’s time to buy existing property to take advantage of the projected inflationary increase in value.

During INFLATION, buy equities.
During DEFLATION, buy debt.

There is some unusual arithmetic relating to purchasing a home. The notion that the value of the land added to the value of the house equals the value of the property is a FALLACY.

In this analysis, we look at real estate as a capitalist. Most conventional appraisal methodologies use a quasi-socialist approach. A capitalist sees property value differently.

In theory, the value of a stock is the discounted present value of its accumulated dividends forever. We can look at real estate in similar manner. Rent can be thought of as stock dividends. For owner occupied property homeowner costs can substitute for rent.

As capitalist, we are concerned with our return on capital. The ratio of rent/down payment is our return on capital.

In 1970 the Federal Reserve had pushed interest rates to 10%. So, the rent house that rents for $1,000 per month,($10,000 per year after insurance and taxes) is worth $100,000 to a capitalist. That is, 10% of $100,000 is $10,000 per year or $1000 per month. In the early 1990's the Federal Reserve pushed the intersect rate down to 5%. Now $1,000 per month, $10,000 per is 5% of $200,000. That rent house became worth $200,000. If the Federal Reserve pushes the interest to 1% then $1,000 per month, $10,000 per is year is 1% of $1,000,000 and if the interest rate goes to 0, divide by 0 is undefined and capitalism fails.

ON OUR GRAPHS

Click on "% Down Payment" button. Each button produces a graph. The RED line is the YIELD, the return on capital after selling the property adjusted for taxes and inflation.

The BLUE line is the return of CASH FLOW adjusted for taxes.

The YIELD can also be thought of as interest rates and compared to what you would earn in a savings account or other investments.

PERCENT DOWN PAYMENT GRAPH

This is the most relevant graph. The buy point is where the CASH FLOW (blue line) becomes negative (goes below the middle line). This is the optimal DOWN PAYMENT percent as seen on the X axis (bottom line) to break even. The YIELD is the corresponding point on the RED line. As long as CASH FLOW is positive you can buy more property forever.

Always do worst case analysis. If you can stand the worst case it's probably a good investment.

INFLATION

In 1980 the inflation rate was 13.91%.

Historically, Inflation has been the driving force behind the rise in property values. Real estate agents mistakenly call this APPRECIATION. When lumber, nails, labor, steel, glass and concrete, etc.. cost more. When new homes cost, for instance, 10% more, an existing homes value will rise 10%, because it would cost more to rebuild it. There is a time lag, but it will catch up. This is how inflation works.

CAPITAL GAINS TAX

Federal income tax rates can have a drastic effect on property values. In 2013 the CAPITAL GAINS rate is 15%, before that 20%, 28% and 35%, in Australia in 2012 it's 50%.

Capital assets like a house are given preferential tax treatment. In theory, CAPITAL GAINS should not be taxed, because in an ideal economy the only way a property can rise in value would be because of devaluation of the currency, called inflation and the rise in value would be nothing more than an adjustment to maintain the purchasing of the dollar.

In 2012 the tax rate for a married couple with $88,000 of CAPITAL GAINS and qualified dividends (which also get special tax treatment) is $0.00.