I told the story of my first real estate transaction previously.  To recap, I purchased Faulkner, a 3-bed, 2-bath 1700 sq ft house, in October of 2007.  Sixteen years later, I still own it and use it as a rental.  If you are interested in owning rental real estate, it is important to accurately track your investment’s performance.  Too many investors gloss over expenses, like claiming that a property is worth $300,000 when you would only clear around $276,000 after closing costs.  Many operating expenses can be too easily hidden, even from yourself.  In this post, I will show Faulkner’s financials as accurately as possible, discuss what they mean in-depth, and explain what this first property has taught me about real estate investing. 

Price Paid

     When purchasing real estate, the price you agree upon is not the price you pay.  For Faulkner, the list price was $169,000, and the purchase price was $158,000.  I put down $150 in option money and $1,500 in earnest money, which were credited back to me at closing.  However, after I paid closing costs, the total price paid was $162,893.55.  The difference is mainly in “settlement” charges, which include a variety of prepaid expenses and fees.  I have included the settlement statement below. 

Keeping Track

     I use several homemade spreadsheets to track my real estate investments.  They aren’t perfect, but they let me follow my investments’ returns over the years.  The following chart tracks my total cash investment into the property, the property’s current value, my loan balance, and how much equity and appreciation I have in the property.  

     I update this chart yearly with how much I believe the property is currently worth and how much I have spent on improvements.  When dealing with investment real estate, improvements and repairs are different.  A landlord can use a repair as an expense, while an improvement (or capital expenditure) depreciates for tax purposes.  An easy way to think about this is that you can write off an expense in the year it occurs, while an improvement is written off over several years of “useful life.”  This concept was complicated by the 2018 tax changes that allowed for accelerated depreciation.     

     I track “Equity if Sold” to know the post-sale value of the property.  You can fool yourself into thinking you have $300,000 when you would not receive that amount in the event of a sale.

Faulkner

faulkner spreadsheet

     The next spreadsheet covers all the income and expenses for the property by year.  I track this for each property I own and have a version that follows all the properties together each year.  This allows me to view an individual property or my entire real estate portfolio over time.  

income and expenses

     The next spreadsheet takes the net earnings (income) from above and tracks other relevant financial information, including mortgage paydown, depreciation, taxable income, and net earnings plus mortgage paydown.  

net earnings real estate

     I’m not simply publishing these spreadsheets to satisfy the financial voyeurs.  Studying the numbers, especially from year to year, can give you a lot of information about the realities of real estate investing.  Let’s look at some of the lessons that Faulkner can teach us.         

Lesson 1:  Real Estate Income is Variable 

     Faulkner’s income has been variable over the years.  I had net earnings of around $5,000 in 2008, 2011, and 2012, but I earned only $480 in 2009 and lost $13,784 in 2010.  What happened?

2010

faulkner

     A married couple that had rented the house since I purchased it suddenly stopped paying rent in 2010.  It seems that the couple got divorced, she moved out, and he decided to destroy my house in his grief.  It took several months and nearly 11k to get the place rent-ready again.  Add this to the lost revenue due to vacancy, and $13,784 came out of my pocket that year.  So, lesson #1 is to keep reserves, as you don’t know when you will have an extensive repair or capital expenditure. 

It could be a roof replacement, prolonged vacancy, HVAC repair, or a distraught divorcee, but eventually, you will have a hefty bill to pay.  Unfortunately for me, this occurred just a few years into my ownership of the property.  Not only did the losses of 2010 wipe out any cash flow I had received up to that point, but I had to come out of pocket for $8,902.  Fortunately, I had cash reserves and could cover the expense, or it could have put me into bankruptcy and cost me the property.

      Another reason for such income variability is that rents and expenses change over time.  Faulkner’s rent has fluctuated but has generally gone up.  From 2018-2020, rent was 32.3% higher than when I bought the property, but as of 2022-2023, it has fallen back to only a 16.1% increase.  Property taxes increased to 29.3% higher in 2021 but are currently only 14.7% higher.  Rent and taxes are tied to the local economy, which, in Faulkner’s case, is heavily influenced by the oil industry.  Insurance costs have steadily risen and are currently 68.9% more than when I purchased the property.  

Lesson 2:  Residential Real Estate is Not Passive

     A common misconception is that real estate investing is a “passive” income source.  This is a myth.  It takes work to purchase the right property.  You must educate yourself on real estate investing and spend time finding and procuring the right rental home.  Once you own it, you must maintain it.  While it is unnecessary to do the work yourself, I have personally painted every interior wall at Faulker at least twice and cleaned it at least as often.  When there is a vacancy, I refresh the property to get it rent-ready.  You can pay someone to do this for you, but it eats into your profits.  I also spend time tracking the financial aspects of the property.  

     My wife manages the property remotely, which also helps keep our expenses low.  We charge below-market rent, which allows us to retain tenants longer and minimize the costs and work associated with turnover.  However, this reduces the amount of rent we collect.  She sends the appropriate service provider to the house (plumber, electrician, handyman, etc.) if there is a problem.  Every few years, we must address a more serious concern (HVAC issue, carpet cleaning/replacement, etc.).

     While we have systems to minimize the work, it is certainly not passive.  A “perfect” year without major repairs currently looks like this.  

RentTaxesInsuranceTotal Expenses EBIDAMortgage Interest EBITDA
21,600.00 3,817.90 2,162.00 5,979.90 15,620.10             –     15,620.10 

     We receive $15,620 per year in ordinary income, and the annual depreciation is $5,891, leading to a taxable income of $9,729.  After being taxed at my marginal rate of 37%, I keep $12,020.  There are at most 2-3 hours of work the entire year, which consists of calling a few service providers and maintaining the financial records.  However, not every year is “perfect,” as 2021 demonstrates.  

faulkner

     We had a vacancy in 2021, and the property needed repairs and improvements that consumed most of the net income for the year.  My wife and I didn’t keep track of how many hours we worked on Faulkner in 2021, but I imagine it was 25 hours or more.  I painted the inside and cleaned up the yard in preparation for a new tenant.  My wife had to coordinate other repairs and work with the realtor to get the house rented. 

Since this only happens every few years, I assume our average time spent on the property is no more than 8 hours per year.  However, this can add up when you have multiple properties, especially if several of them need a lot of work in a single year.  Using this average, if you own 20 rental properties, you will work 160 hours a year or four 40-hour weeks!  This is far from passive and can be burdensome if you have a full-time job or other business ventures.  

Lesson 3:  Real Estate is Not Always Wildly Profitable

    As you can see from the table above, Faulkner has made a net income of $163,165 since 2007.  There was only $14,428 of mortgage paydown since I paid off the loan very early, which increased the total profit to $177,593.  

     My cash inputs for this property were $20,694 for the downpayment and closing costs and $123,272 to pay off the loan (loan balance minus the loan paydown).  Therefore, I have a total of $143,964 of my cash in Faulkner.  I have received $163,165 in net earnings over the 16 years I have owned the property.  I have been able to invest this income each year after paying taxes.  Investing this income into an 80/20 mix of a total stock market index fund (VTSAX) and a total bond market index fund (VBTLS) increases the total to $184,360.  The property is currently worth $300,000.  Assuming I could sell it for this price and pay 8% closing costs, I would net $276,000, $132,034 of which is profit.  Therefore, my total profit is $316,394.  

     The stock market returned an annualized 9.98% from 2008 to the current year.  If I had simply invested the $20,694 downpayment into the same mix of stock and bond ETFs as mentioned above (rebalanced yearly) and waited, it would be worth $74,975 today, $54,281 of which is profit.  To complete the comparison, I would also have to invest $123,272 (the amount I spent to pay off the loan) from 2014 to the current year, when the market returned 11.83% annualized.  This portfolio would be worth $374,451 today, contributing $251,179 in profit for a total of $305,580.

     While Faulkner has produced a larger profit than investing in the stock/bond market, the returns have been remarkably similar.  When you consider that my wife and I have managed the property over the past 16 years and that I have done many hours of work at the property, Faulkner has really underperformed the market.  

     I consider this a typical residential real estate investment that any medical professional could make.  The property was local, was purchased off the MLS, and was move-in ready.  I used a conventional mortgage, and the geographic area did not undergo any significant gains or losses over the years.  The only thing atypical about the example is that I paid off the loan early, which I will discuss next.  

FaulknerVTSAX/VBTLX 80:20
Cash Invested 200720,69420,694
Cash Invested 2013123,272123,272
Current Accumulated Profit$318,881$305,580

Lesson 4:  The Power of Leverage

     I paid off the mortgage in 2013 because I got angry with the mortgage company.  After a few years of owning the property, I grew tired of paying the PMI.  I had been paying extra on the mortgage each month and reached 20% equity.  I called the lender about removing the PMI, and they told me that I needed to have 35% equity or have made 120 payments before they would remove it. 

This conversation occurred after the great financial crisis, but home prices had not dropped in this area, so it wasn’t a loan-to-value issue.  Looking back, I’m not sure what they told me was correct or legal, but it pissed me off enough that I just paid off the whole loan instead of looking into it further.  I owned a few more rental properties by then, and Faulkner had the highest mortgage rate, so I just paid it off with some cash reserves I had amassed.   

     Paying off the mortgage had several effects.  On the positive side, it improved the property cash flow, as the mortgage payment/interest/PMI was the largest expense.  I suddenly received a significant amount of money every month.  A paid-off property reduces risk in your portfolio and acts as collateral for other types of loans.  On the negative side, paying off a mortgage increased my tax burden and decreased my overall returns, which I will demonstrate next.  

     If you only consider the first six years when I had a mortgage, the overall annualized cash-on-cash return was 11.0%, not including any appreciation during that time.  This period includes 2010, when I had a significant loss on the property.  Since the loan was paid off, the return has been 5% annualized for the last ten years.  This demonstrates the power of leverage.  Let’s look at what would have happened to the total returns had I not paid off the mortgage and instead continued using leverage.     

Downpayment$20,694
Net Income$62,502
Loan Paydown$41,062
Loan Balance $101,138
Equity if Sold $174,862
Total Profit$237,364
Annualized Return16.47%

     As you can see, the returns on a percentage basis are much higher than my actual returns, but the total profit is less.  However, I would still have had to invest the cash in 2013 for this to be an accurate comparison.  Had I purchased VTSAX/VTBLX in 2013 with the same amount as above, this would have increased my profits to $488,543.  Finally, I could have invested the cash flow I made each year, improving my overall returns to $517,127. 

     Using leverage can aggressively boost your returns, but if there is a market downturn, it can work against you with equal potency.  I paid off several of my early properties because there was a limit of 4 conventional mortgages then.  It made more sense for me to pay off my lower-priced properties and buy more expensive properties using traditional mortgages.  You must consider how much leverage you are using across your entire portfolio.  I am not anti-debt; I am pro-using debt wisely.  While leverage is the fuel of this type of real estate investing, it must be used cautiously so you don’t get burned.  

FaulknerVTSAX/VBTLX 80:20Faulkner – Levered
Cash Invested 200720,96420,69420,694
Cash Invested 2013123,272123,272123,272
Current Accumulated Profit$318,881305,580$517,127

Lesson 5:  Don’t Forget About Taxes

     Real estate is often touted as having tremendous tax advantages.  While true, it may not be as helpful for the average investor as advertised.  Let’s look at real estate taxes.  

Depreciation

     As a residential real estate property, I can depreciate 1/27.5th of the value of the improvements (not land) each year.  In this case, the land value is negligible, but depending on your property location, it can be a substantial part of the purchase price.  Since its purchase, Faulkner has produced a net income of $163,165, which is taxed at my ordinary income rate.  On that income, I should have paid 37%, or $60,371, in taxes.  However, I have depreciated $95,236 on the property, dropping the net income received to $67,929 ($163,165 – $95,236).  This means I have only paid $25,134 in taxes during that time, deferring $35,237 ($95,236 x 0.37).  This tax deferral allows more cash in my pocket, which I can use to make further investments.  

     You must pay depreciation recapture when you sell a property unless you complete a 1031 exchange.  However, most everyday real estate investors don’t use this method, especially for single-family homes.  However, there are still tax advantages regarding real estate depreciation recapture, which is capped at a 25% rate.  If I sold Faulkner, the government would recapture taxes on the depreciated amount, $95,236.  But I would only have to pay $23,809 (0.25 x $95,236), saving me $11,428.  This arbitrage on real estate depreciation depends on your marginal tax bracket, but many medical professionals have a marginal rate above 25%.  

Capital Gains Tax

     Additionally, I would have to pay long-term capital gains on the appreciation if I sold the property.  I would net $276,000 from the property sale using the above examples.  My cost basis in the property for tax purposes is $158,000 (purchase price since there is no mortgage) + $10,459 (capital improvements) = $168,459.  I would therefore owe 20% capital gains tax on $107,541 ($276,000 – $168,459), or $21,508.  

     If I sold Faulkner, the total taxes paid on the sale and the income generated would be $25,134 + $23,809 + $21,508 = $70,451.  Since my total profit would be $318,881, the overall tax rate is 22.1%.  This rate is certainly less than my marginal tax rate of 37% but is more than the current top long-term capital gains rate of 20%.  

     For the 80/20 Stock/Bond portfolio described above, I would have paid roughly $5,178 in taxes on the dividends from the bond portfolio, $8,285 on the dividends from the stock portfolio, plus 20% of the capital gains, or $61,116.  The total tax paid would be $74,579, or 24.4%.  This assumes a 37% marginal tax bracket, yearly portfolio rebalancing, and a 2.5% average yield on the bond portfolio and 1% on the stocks.  

     Finally, for our levered Faulkner example, there are two parts: real estate and investments.  For the investment portfolio, I would have paid $4,166 and $6,665 in ordinary income taxes on dividends for the bonds and stocks, respectively.  The capital gains would have been an additional $50,260 for a total portfolio tax of $61,091.  For the real estate portion, the interest on the continued mortgage payments is considered an expense, which reduces net income.  I would have a net income of $62,502, but with a depreciation of $95,236, the taxable income would be -$32,735.  Since you can use these losses against other gains in your portfolio, that would be a net tax of -$12,112.  When the depreciation is recaptured, the cost would be $23,809.  Finally, the capital gains would be $143,709.  When taxed at 20%, it equals $28,742 for a total tax of $101,530, or 19.4%.

FaulknerVTSAX/VBTLX 80:20Faulkner – Levered
Current Accumulated Profit$318,881$305,580$522,952
Total Tax Paid$72,629$74,579$101,530
After-Tax Profit$246,252$231,001$421,422
Effective Tax Rate22.1%20.3%19.4%

Consider Return on Equity

     We have been discussing return on investment (ROI); however, real estate investors must also consider their return on equity (ROE).  For example, in 2014, Faulkner made $16,941 in net income.  My return on investment was 9.61%, while my return on equity was 8.85%.  Fast forward to 2020, and the net income was $18,094.  My return on investment was now 9.93%, but because the property had appreciated, my return on equity was only 7.62%.  I made more net income, which increased my return on investment, but because the property appreciated, the return on equity was lower.  

     This concept is especially important with properties that have appreciated and still have a mortgage.  The returns on investment will be high due to leverage, but the return on equity will be relatively lower.  Using the theoretical example where I didn’t pay off Faulkner, the 2014 ROI was 26.40%, while the ROE was 14.55%.  By 2020, the ROI and ROE were 33.50% and 10.76% respectively.  While better than the unleveraged example, the ROE drops precipitously in this scenario.  

     When you have a property that has increased in value without a commiserate rise in net income, your ROE will decrease.  This is relevant because if you sold the asset, you could invest your equity in something that potentially provides a higher return.  This is exactly why I sold two rental properties in 2022 and one in 2023.  The houses had increased in value, but the rents had not increased as much.  I felt I could redeploy that capital into another investment more profitably while bringing my total portfolio asset allocation closer to my target.  

Conclusion 

     After a review of the financials from Faulkner, I consider it a success.  I have earned $246,252 in after-tax profits during the 16 years I have owned the property.  My returns have (barely) outpaced a comparable investment in the stock/bond market, albeit with more effort on my part.  In retrospect, it would have been better to have kept the mortgage on this property, even with the PMI.  My returns would have been higher if I had invested the money in 2013 instead of paying off the mortgage and would likely have been even higher if I had used the money to purchase even more properties with leverage. 

Ultimately, the most important aspect of this investment was what it taught me.  Even if my actions were not perfectly optimal, I still took action.  I improved my financial position and learned lessons I have used in subsequent real estate investments, some of which have been much more profitable.     

    If you are interested in real estate investing, we will publish more upcoming articles on the subject.  Heather and I believe it is a great way to grow your wealth, diversify your assets, and have some fun along the way.  However, if you don’t feel like real estate investing is for you, you can see from this exercise that you can do just as well by investing in stocks and bonds.  The key is to get started, be consistent, and educate yourself.  Let us know in the comments below if you have any questions or comments.  Please subscribe so you don’t miss any upcoming posts.  Thanks for reading!