Hello friends and welcome to another episode of Ask Marco where I answer your investing related questions.
Today’s question comes from Lester and Lester writes in and he says, hi Marco. I discovered your podcast this year and have been an active listener ever since. In my opinion, it has been exceptional content among the number of real estate investing podcasts I’m subscribed to because the information is succinctly delivered in each episode. We’ll thank you for that. Similar to you, I’m located here in Southern California, specifically on the border of Los Angeles and Orange County. I understand that out of state real estate investing is the way to go, but I’m 30 years old, not a homeowner, and I have plans to be married and have kids within five years. Wow. A very specific goal, Lester. That’s great. So he goes on to say, I have about 20% of a median home price in LA saved up and I am weighing my options.
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Should I rent my whole life? If I plan to stay in SoCal and invest out of state, should I buy a home with a lot of rooms in California and quote-unquote house hack and or pursue ADU eligible homes, ADU meaning, uh, additional dwelling unit, ADU eligible homes or homes with Ady use in California to makes sense of the numbers. What would you suggest I do? Is there another path I’m overlooking? At any rate, I appreciate you and the work you do with the podcast. Passive real estate investing. Sincerely, Lester Lester, thank you so much for the kind compliments and for writing in, and this is a brilliant question because a lot of people have a similar situation in terms of affordability in expensive markets such as California or New Jersey, New York, Washington, D, C, Denver, Colorado. And the list goes on. Uh, it just happens to be very expensive here in the Southern part of California and in the Bay area up North.
So here’s my quick take on this. You know, it’s always nice and even sexy to think that you know you’re a homeowner and you’ve got that pride of homeownership and you can tell your friends and family, yeah, I own my home and really I say own in quotes because you actually don’t technically own the whole thing. If you have debt on it, you know the bank could take it away from you if you don’t pay your property taxes or your mortgage payments. Ultimately you call it your own home and, and if it’s free and clear, then yeah, I guess you own it free and clear. But let’s look at it this way. So in orange County where you border and I live, the median price in Orange County is about $720,000 and that is very expensive. And for most people listening to this, it probably sounds very high.
If you consider a 20% down payment, that’s $144,000 now let’s just clarify something here. The minimum down payment requirement for a conventional loan is technically 3% and the minimum down payment for an FHA loan is three and a half percent and then there are some special loan programs out there that even allow for 0% down payments. Now before you get too excited, understand something 20% down is considered ideal when purchasing a home and some people refer to this as the 20% rule and there’s really a basic reason for this and that is is because when you are under at or below 80% of the value of the property with your financing, you avoid paying mortgage insurance, which is not something you really want to pay. So I actually ran the math very quickly before I started recording here. If you were to purchase a property with 20% down, you would obviously avoid mortgage insurance.
But if you hypothetically put only 5% down on that property, the $720,000 median-priced home in Orange County, comparing that to putting 20% down over the course of 30 years, you would save $129,880 in interest and mortgage insurance. So basically $130,000 extra is what it would cost you to save quote-unquote, that 15% difference between a 20% down payment versus a 5% down payment, which is certainly more realistic and palatable for most people where a lot of people in Southern California, but let’s look at this a little differently. Let’s just say option a is you become a homeowner and you purchased that $720,000 single-family home, typically a three-bedroom, two-bath or three-bedroom, three-bath, uh, with 20% down or $144,000. Now you can call yourself a homeowner and you’ve got the mortgage payment, the principal and interest plus a HOA fees, property taxes and um, and home insurance versus continuing to rent.
And I actually did a quick search on Zillow and I looked at three-bedroom, three-bath, and three-bedroom, two-bath homes here in Southern California, particularly around the area where I live. And you can move into a home, uh, with monthly payments, which covers everything I just described for somewhere around $3,500 per month. Or you can rent the same property for about the same amount, sometimes a little bit less. So dollar for dollar. You’re getting more or less the same amount of square footage as far as your living room, uh, or living quarters. Um, but you have no worry in terms of maintenance and repairs and other factors because you’re actually renting someone else’s home and they’re responsible for maintenance and repairs and any capital expenditures that come up over for, for the mechanicals of the property. So, um, no, you’re not building equity this way.
Um, and you are avoiding maintenance and repairs and, and future home related costs. So maybe there’s less worry. But when we look at this from an investment perspective, you can take that $144,000 and you can invest it in into four quality properties in let’s say B plus areas. And I’ve actually taken one of the properties off of our website as a real live actual example. And so the property I’m looking at right now, and it’s probably gone by the time you hear this well I’m sure it’ll be gone. It’s a property in Springfield township in Ohio on Mayfair street. It’s a four-bedroom, three four-bedroom, two bath home, 1600 square feet with a purchase price of $121,000 and it rents for 1200 a month. So it’s right around that 1% rent to price or rent to value ratio. It’s in a B plus neighborhood.
It is very appealing. It has great curb appeal, nice neighborhood, nice street. The numbers look great, but I took your 144,000 and I chopped it into four parts. So let’s just hypothetically say you take the 144,000 that you have as a down payment towards a home here in California and you put 25% down, not 20 but 25% down, which is just being more conservative and you acquired four properties like this. What you would end up with, and just for the sake of this audio recording, I’m going to round some numbers and just summarize your net results. Ultimately what you’re going to have in your first year across those four properties is $11,740 per year in net cash flow, which works out to be roughly about a thousand dollars a month, 978 and when I say net cash flow, I’m actually factoring in the deduction of your vacancy. So we have a vacancy factor or vacancy allowance.
We’re assuming there’s going to be a vacancy, and I used 5% for that and we are also budgeting 5% for maintenance and repairs. So I’ve deducted that. So what’s left over is what I’m referring to as your net cash flow. And it’s a positive cashflow of about a thousand dollars a month or Wilkes just short of $12,000 a year. But then let’s stop and take a look at the magic of real estate where things start to get exciting after three years, five years, seven years, 10 years as things start to grow in terms of equity. And of course you have little bits of appreciation and you have small increases in your rent, sometimes large, but you know, increases in rent over time, maybe not year after year, but every time you have a tenant move out after two, three years, maybe you bumped the rent if that’s what the market supports.
But I made some very conservative assumptions here and I just wanted to give you a quick snapshot of what that looks like in five years. So that same portfolio, four properties that you purchased through 25% down in five years would have cumulated $19,000 of net cash flow. So you now are $19,000 ahead of the game in cumulative net cashflow. Now that’s on one property. So multiply that times four and you’ve got 74,000 just under $74,000 of cumulative net cashflow on those four properties after five years. When you look at the equity gains, this is everything, the appreciation, and amortization of the loan, you’ve got $31,196 per property. So times four is 124,784 rounding it up, let’s call it 125,000 of net equity gain after five years. If you divide that into your original down payment and closing costs, because we’re now calculating a return of investment just from the equity on your original investment, that’s a 92% increase, a 92% return on your investment of your down payment and closing costs.
So when you add all this up and you just truly bottom line at all from a, an internal rate of return perspective or what you might call an annualized rate of return. So let’s just take a look at what you, what you’ve made over five years and divide that by five and average it out to the annualized return. Uh, it’s 19.8%. So let’s think about this in five years with those four properties, your cumulative net cash flow is $74,000. Your, your equity gain is 125,000. And in terms of percentages, what was my annualized return each year over those five years? When you annualize that, it’s 19.8, almost 20%. Very hard to do that anywhere else. Plus you have the tax benefits of the depreciation, which helps to shield, minimize, and, and potentially eliminate whatever tax impact you would have on that cash flow. And that’s a question for your tax advisor, of course, but because there are very, very creative ways to get even better than that, if you have the, uh, the deductions to make it work.
But this is the other option. So your plan is to buy a home plan B is to invest it in some rental properties. Um, you know, again, think about this objectively, not emotionally. Yeah, it’s cool to say, yep, now you know, this is my home. I bought it. And um, you know, I, I’m paying it off. I have my mortgage and I’ll own it in through to 30 years, 25 years, 20 years, whatever it is. But if you want to build a real estate portfolio and you take this plan B, follow that path and keep building upon it, you’re going to get to the point where your passive income from it, your net cash flows will cover the cost of your rent here in California or your mortgage payment, your principal interest, tax, insurance of whatever home you end up purchasing down the road.
And last not least, just to add one more layer on all of this, something to think about if you are of the school or of the mind that you think we are nearing a real estate market cycle top here in Southern California, which many believe we are. Uh, and some people predict, and I know some of these professionals that very reliably predict market cycles in California, they think we’re, you know, within two to three years of, of peaking and enrolling over and in some markets it’s actually all you’re already doing that now. But if you think we’re within a couple of years of that happening, why would you want to buy into the market here? Nearing a top, assuming we’re nearing a top and then writing that down for two, three, five years, however long it takes for us to kind of go down that down cycle of the real estate cycle before we hit the trough and then bounce back up and hopefully continue on up to whatever the next high is.
So when you compound scenario B with that reality that’s going to happen at some point, then it might be wise to just sit tight rent, get better value for your dollar from renting and applying your investment capital or that down payment as investment capital and building a portfolio. All right. I hope that made sense. Um, I think it did, but if you’re not sure, just shoot me an email and I will answer your question or even just connect you with my team. All right, well that’s it for this particular episode. It was a mouthful and I went longer, way longer than I expected, but anyway, I am going to continue answering these questions as best as I can. I’ve been doing a lot of traveling lately, uh, mostly for business. So if you have a question about real estate or investing, just shoot that over to me. Hit the ask Marco button on passive real estate investing.com. I really appreciate when you do that and if you haven’t already remember to subscribe to the show. Thanks for listening. We’ll see you all on our next episode.
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