Is David Bach’s Math Misleading?

by golbguru on May 31, 2007

automatic millionaireI was reading David Bach’s book “The Automatic Millionaire” on the flight back home from our Philly/NY trip - except for some little excitement (for the wrong reasons) while reading his views on real estate, the book almost put me to sleep (sorry Bach fans). May be it’s not Bach’s fault here - there is a lot of stuff on personal finance (by various authors) that make me yawn with increasing frequency after a dozen pages or so.

Anyways, back to the point of interest. In one particular section in the book (titled “Six Reasons Why Homes Make Great Investments“), Bach starts painting a very rosy picture of investing in real estate. While some of the reasons are OK, I was not comfortable with the manner in which a couple of them were explained. For example, in reason #2, he starts with explaining the concept of leverage and then jumps to calculating returns on investment. Here, he tries to show how real estate investment can yield handsome returns by using the power of leverage. This is what comes next:

Let’s say you are buying a $250,000 home with a down payment of 20 percent. What this means is that you’re putting in $50,000 of your own money and borrowing the remaining $200,000 from a bank. Since you’ve put in only one fifth of the purchase price, you’ve got five to one leverage. Now let’s say the value of the house increases over the next five years to $300,000. Given that you’ve put in only $50,000, the $50,000 increase in value means you’ve effectively doubled your money. This is the power of leverage.

What!?

Am I being too critical or that just doesn’t sound right? That’s not telling the whole story. What about the payments that you have made every month over those five years, isn’t that a part of your investment? A quick calculation using a generic mortgage calculator shows that by the end of five years, a $200,000 mortgage (at a reasonable 6% rate of interest) would cost about $58,000 in interest alone (plus some amount of principal is paid back too ~ but let’s ignore that for the time being). Shouldn’t such costs be taken into account before making claims about doubling money? In fact, for this particular set of numbers, if you sell the house after five years, you would be making a handsome net loss.

If you are not yet convinced, here are some specific problems with David Bach’s argument:

  • Let’s extend Bach’s calculation a little further. What if you put down only $25,000 instead of $50,000? With his calculation that would give a 200% rate or return. For $10,000 down payment that would be a 500% rate of return. Man..isn’t buying a house really profitable?! ;) At this rate, Bach could easily tell you that if you don’t put anything down you get $50,000 on a $0 investment - now, I don’t think there are many people who could divide by zero (someone once mentioned to me that Chuck Norris can), but if Bach continues with this argument, he might as well perform the division and declare an “infinite rate of return” on investments. :)
  • The doubling money argument totally ignores any kind of interest rates (his logic is applicable only when you borrow money at 0% interest rate and don’t make any payments for five years ~ and no one’s ever going to give that kind of a mortgage). For someone who is trying to explain potential gains using leverage, this isn’t a good sign. Profitable financial leverage cannot be explained without explaining the difference between the rate imposed on borrowed money and the rate of return that you get when you invest the borrowed money. For example, if you borrow $200,000 at the rate of 6% and invest it for a 4% rate of return, then it’s not a very wise way of using financial leverage ~ you will be losing money in such a deal (of course, there are complications like cash flow considerations - when you rent whole or part of your property, but we will ignore such issues for the time being - because Bach does not consider them either in his explanation).

Bach keeps up with this questionable math in the next paragraph:

Over the last five years, many homes have doubled in price. Think what this means in terms of leverage. If you invested $50,000 in a $250,000 home five years ago and it’s now worth $500,000, you’ve made $250,000 on a $50,000 investment. In investment circles, that’s called a five-bagger - an amazing 500% return on your money.

What does that “500% return on your money” sound like to you?

*cough* real estate agent *cough*

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{ 38 comments… read them below or add one }

1 Sun 05.31.07 at 7:38 am

To make my life easier, I just don’t read any book with the word Millionaire in the title. How many copies of this book have been sold? And how many millionaires are in this country?

2 Kevin 05.31.07 at 7:42 am

You know, you’re absolutely right about the way real estate leverage can be overstated. Then again, it’s still more complicated than your coverage too.

First, I feel that thinking about real estate in terms of leverage and return on investment should generally be reserved for evaluating properties which you’ll be renting out and not your own home. You can apply it to your home, but it makes less sense.

In terms of true real estate investing, however, David Bach’s math is fine if you are purchasing a property from which you can derive non-negative cash flow.

If you are renting out a property, and the rent covers the mortgage, taxes and maintenance, then you have a zero cash flow. Your return on investment upon selling the property really is based on the sale price versus what you put down. Your RENTER has been paying the costs, not you.

You can do something similar when thinking about your own home, but it is kinda shaky. You would have to consider your housing cost to be an expense that you pay REGARDLESS of whether you rent or buy and then consider the difference in what renting would cost you versus owning. Any extra that it costs to own would be additional investment money, so your real investment would be the sum of those additional costs plus the purchase costs.

You can get unlimited returns on real estate, but that’s just because of the way we calculate ROI and doesn’t imply that there is a free money machine. Locating investment properties that you can get cheaply enough to generate positive cash flow from day one is hard to do. Folks like David Back and Robert Kiyosaki make it sound easy, but it’s a lot of hard work, dedication, and risk. Kiyosaki does mention that he searches through hundreds of properties yearly, but buys fewer than 6, but he dwells more on the big wins than the tough slog. It can be done, but even with a lot of expertise it is likely a full-time job.

3 Brad 05.31.07 at 8:04 am

Yes, he does leave an important factor out of the explanation, and it results in an exagerrated return. But the leverage point is still valid, at least if we’re talking about a primary residence (where your monthly payments can be compared to the cost of rent on a similar house). Take his example: 250k house, 50k down, 30 year mortgage at 6%. Your payments are about $1200, and let’s factor in taxes and insurance at $300 per month (this will vary considerably, but that’s above what mine would be in this area). So your total costs are around $1500 per month. Suppose that rent in your area on a similar house is about $1000 per month (again, this is very conservative for my area– this would be closer to $1500 here). You pay $500/month extra to obtain this house over renting (plus a $50k downpayment). At the end of 5 years, if the house has grown to $300k (a fairly conservative 4%), you have paid a little under $80k (above renting) and have about $120k in equity. This equates to an annual return of a little over 9.5%, and does not include the tax advantages of home ownership. 9.5% is a solid ROI. With a smaller down payment your ROI goes up considerably ($25k DP leads to an annual return of more than 11%).

There are a lot of factors to consider in the equation. In my area, rent and home cost are almost equal, so my ROI is considerably higher than this. In other areas, taxes are high, rent is low (comparitively) and your ROI would be considerably smaller. Also, if your appreciation is better (or worse) than the 4% in his example, your results will be much different. Bach oversimplified in the example he gave, but in the end the huge leverage involved in real estate can be a really big winner if you’re in a reasonable market. DO YOUR HOMEWORK! Every market and every house is different. Don’t count on Bach’s math and don’t count on mine– use the tools available and do the math yourself.

4 Kevin 05.31.07 at 8:57 am

Brad: I think we’re on the same page — David Bach dramatically oversimplifies in order to make a point, and in doing so exaggerates the power of leverage. The more I think about it, the sillier it seems to me to try to calculate ROI on your home anyway. If I buy a rental property ROI is going to be high on my list of considerations, but for my home? I don’t want to see it lose value, but ROI is just not something I’m going to calculate.

Sun: The number of millionaires in the U.S. can only be estimated. According to Wikipedia ( http://en.wikipedia.org/wiki/Millionaire ) between 2 and 9 million US households have a net worth (including primary residence) of at least one million dollars. In 2005 there were about 113 million households in the US, so between 1.7% and 8% of US households are millionaires by net worth.

5 KMC 05.31.07 at 9:17 am

I love Sun’s rule. I’ve now adopted it as my own. Thank you Sun.

6 golbguru 05.31.07 at 9:39 am

Kevin and Brad: I understand what you are saying. Depending on situation (and like Brad says - *reasonable market*) renting may not be profitable than buying a house - we can math our way out on either ends (to show how renting is profitable or how it isn’t). Unfortunately, Bach does not even address such possibilities or mention “cash flow”. His discourse starts with a biased statement:

The fact is, you aren’t really in the game of building wealth until you own some real estate.

Brad: “There are a lot of factors to consider in the equation. In my area, rent and home cost are almost equal..” …That’s awesome! In this case, buying a house makes sense. But, I am not sure there are many areas in US with that equation - In all probability most housing markets won’t fall in that category.

Kevin: I totally agree with your opinion that these things are much more difficult to get into that what these financial gurus make them out to be. Perhaps, they are all hung up on making things sound nice and easy (people like reading nice and easy stuff) to improve the sale of their books.

Sun and KMC: I hear you. :) I think the book sold more than a million copies in about a year’s time. Increase in the number of millionaires haven’t been commensurate with that number….but you could also blame it on laziness and stuff like that. ;)

7 plonkee 05.31.07 at 9:53 am

Is there really no explanation that the power of leverage is complicated by paying interest on the mortgage?

Also, leverage doesn’t really make real estate a good investment, you could use leverage on most investments. If you want to argue that interest rates are better on home loans then you need to bring interest rates into the equation anyway.

And lets not forget that leverage will multiply any losses as well.

I think I need to stick to Sun’s advice.

8 Brad 05.31.07 at 9:59 am

Kevin: ROI makes sense on a home when you are considering renting vs. owning, because ROI essentially measures the financial advantage/disadvantage of owning. Personally, this return has made a big impact on my net worth.

golbguru: I agree on Bach’s bias and the woeful ignorance of detail in his example. As for my situation . . . it’s a relatively small market. The larger the city, the larger the premium on land and homes. I think that’s a fair generalization. We moved out of an $800/mo 1000 sq ft apartment with no garage and into a 1500 sq ft house with a 2-car garage, and with interest and taxes my payment is about $850. That was a big increase in living conditions for a very small price. It has also appreciated about 17% in 2 years . . . my ROI has been considerable. But would that be possible in New York? San Francisco? Chicago? Atlanta? No way. Buying a home is a luxury in big markets. I’m fortunate that it’s such a no-brainer of an investment here.

9 Customers Revenge 05.31.07 at 10:22 am

Wow, people beat me to an explanation of leverage. Basically, yes you have to live somewhere and it is perfectly valid to compare against the rent you would pay. However, it is really important to compare against the rent you would really pay to rent your 2 bedroom apartment versus the mansion your realtor talked you into getting.

Second, over the long term rents and ownership need to be aligned. In many inflated markets, where prices do not reflect anything except a bubble, there is no incentive to buy rental properties because the rent doesn’t give a 10% return after covering the mortgage. To me, if it ain’t worth buying to rent, then it also ain’t worth buying to own. Normally that’s not the case. You buy, get your leveraged return for holding and get a leveraged appreciation also.

10 broknowrchlatr 05.31.07 at 10:37 am

I wish this really did work this way.

So, $50k down on a $250k house in year 0.
Sell house for $500k in year 5. You now have $300k. Now buy 6 houses with the same deal. In year 10, sell the 6 and end upwith $1.8MM and buy 36 houses. Sell them at 15 years and you end up with $10.8 Million!!

Is this how you become an Automatic Millionnaire?

11 Lazy Man and Money 05.31.07 at 12:02 pm

I think Bach should explain it a little better, but to do so in significant detail would probably take another 10 pages and pull the reader away from the point he was trying to make. It’s not as simple as he makes it out to be, but that doesn’t mean you should discount leverage and real estate. Leverage in real estate is powerful and I’ve seen it make a lot of money for a lot of people. The case to consider is the case for having a renter. You may be losing money every month, but you may find that 4-5% appreciation on the whole home may be worthwhile. For instance a $250,000 home at 4.5% appreciation should net $11,250 a year. It would appear that this could be a profitable strategy as long as you aren’t losing around $900 a month - and are not paying too much for the home in the first place.

You may also consider that over time rent will go up with inflation, but the mortgage will not. If you bought the average home 30 years ago and had your mortgage then, it would probably be just a few hundred dollars. Yet you could rent it for 2-3 times that price today.

12 Kitty 05.31.07 at 12:26 pm

Smart Women Finish Rich changed my life when I finally read it last spring and began to take agressive control of my finances. At the same time I take what he has to say with a grain of salt. Still this is good - 5 years ago I said “I’m 40, why bother? Cute shoes. I’m gonna buy them.” Now I’m about to turn 45 and have a solid if infantile 401(k). Just upped my contribution another percent to 11% with a goal of 15% by this time next year. I have a firm financial plan in place. I have an online savings account at a great rate. I own my own home. I have a small amount of cc debt which I manage at little to no interest rates and do not add it to unless I know I can pay it off in a month. So while I don’t believe I will ever be rich I do believe I am about 100% better off this year than I was before I read his book last year.

13 pfstock 05.31.07 at 2:43 pm

You took the words right out of my mouth. Or possibly, out of my blog, PFStock. See my November 2006 post ( http://pfstock.blogspot.com/2006/11/david-bach-90-good-10-evil.html )

Anyway, I will assume that you came up with your reasoning independently. In his treatment of the term “leverage”, Bach doesn’t even mention the potential downside of leverage anywhere in the entire 240-page book; he only discusses the upside. Any responsible coverage of the topic would explain that leverage is a double-edged sword, where it is possible that one can lose more than their entire investment.

14 Rainer 05.31.07 at 4:33 pm

It’s not just Mr. Bach that teaches this on simple terms. You can add “Rich Dad, Poor Dad”, “Nothing Down for the 2000’s”, and a host of others that want to sell books.

I think they are right, but ignore one simple aspect: luck. You can call it risk, luck, a surprise; whatever you call it, it’s the unknown. They ignore the fact they and hundreds of the people following this method are lucky. They’re either gifted (a.k.a. lucky) at spotting good properties on the cheap, or lucky that nothing went wrong on the property. The tens of thousands that have failed using leverage never get to write the books.

I think the best return is the easiest. Don’t use debt to finance an investment (only exception in my book is to start a business, and then only if you’re willing to loose it all and start over). Using cold cash is the easiest because you have one less math equation to worry about: the bank’s interest in your property. If that home is vacant for 2-3 months, you better hope you have money socked away to pay rent. You also better hope you don’t have to replace the roof or A/C. Either would cost you 10k-25k on a 250k house. Don’t have the money? The bank gets their share plus their expenses.

Oh, and another point on Bach’s comment, “Over the last five years, many homes have doubled in price”: he isn’t considering this also priced a huge number of people out of the market, reducing the speed at which you can sell that house.

golbguru, you are right on in my opinion that the math doesn’t add up. Too many people are duped by cute titles (i.e. “Automatic Millionaire”) and simple advice. I knew someone that bought one of these “kits” that will make you a millionaire in real estate. She did hit 1 Million in property values, but lost every dime of it when the houses didn’t rent, roofs needed to be replaced, etc., all in just 12 months or so. Going cash only means when the rent isn’t paid at most you need to put in $100-300 for insurance and taxes. Hopefully, your last tenant made that easy since you didn’t have a mortgage to give that money to someone else.

Oh, and one other point: Bach makes you a millionaire on paper. You have to sell the property to make money, or take out an equity loan to pay for expenses as they arise. A stock, bond, or savings account can be cashed out quickly and easily when tough times hit.

15 Taylor 06.01.07 at 5:47 am

Hi -
I don’t mean to be rude - I quite enjoy reading this blog, but I am a little touchy when it comes to rental property - I have a fine return on all of my rental properties, each of which has also appreciated significantly in a city with a low (though still positive) rate of appreciation. I am not lucky, merely hardworking and observant while maintaining my full time job.

I am writing to ask a question - do any of the posters on this string actually own investment real estate? If so, do you have any bad stories (delinquent renters, roofs that cost $25K to fix, homes that are vacant for 2-3 months)that support your statements?

Playing with the numbers is one thing - and I don’t know anyone who has a $250 rental property - but actually seeing your tenants’ rent show up in your bank account and slowly pile up after expenses is very satisfying…

16 Flexo 06.01.07 at 6:17 am

Bach isn’t necessarily talking about rental properties, he’s talking specifically about “homes,” ie., where you live, not where you rent out your property. If there’s no rental income, only expenses (including mortgage principle and interest), then you’re relying only on appreciation to cover the leverage… risky idea unless you believe that real estate, like tech stocks in the 1990s, will “always go up.”

17 golbguru 06.01.07 at 8:42 am

All: I really appreciate the thoughtful comments. On leverage - yup, both sides of leverage should be explained. I wonder how would Bach put it if the house price were to drop 10% in five years. I am not sure he will stick to his inflationary mathematics at that time.

Lazy: I am not underestimating the power of leverage - I am just making a remark on how it can be wrongly portrayed. I agree that it would have taken a few pages to explain this concept, but given the fact that he can write a whole book on “Latte Factor”, adding 2~3 pages wasn’t a big deal - especially since it’s something that he so vehemently supports.

Kitty: Personal finance books work in mysterious ways for different people. So I wouldn’t make a blanket statement about all such books being bad or anything. It’s just a personal opinion that some books I have read on this topic were quite boring. :) It’s sort of like a music CD ~ you like some songs but not all ~ and different people like different songs. Anyways, I am glad that you have found the right path through one of his books.

pfstock: yeah you wish! Thanks for pointing back towards your article. I will include it as additional reading in this post ~ it’s good to know that there are some people who share my views. :)

Taylor: “I am writing to ask a question - do any of the posters on this string actually own investment real estate? ” …Hmm, I am not sure you will get many “Yays” for that. Thanks for sharing your perspective. But like Flexo says in the next comment, Bach doesn’t even mention the renting cash flow as one of the positive aspects of buying houses.

Flexo: You are right on target. He doesn’t talk in terms of renting homes to generate cash flow - he is talking in terms of “you will live here happily forever” homes. I wish he had mentioned a few words about how much of a gross generalization his statements are with respect to the appreciation.

18 MossySF 06.01.07 at 10:05 am

I did the landlord duties for years (my parents’ rentals) and it sucks. It sure ain’t passive income in my book.

Beyond the typical headaches (renter turnover, late payers, fixing crap, replacing crap), I remember maybe two major issues that costed my parents about 10K+ to correct. What did happen more often was my parents trying to get top market rates and then having it sit empty for a month or two. One time, an applicant offered $800/mo but my mom held out for $850/mo. Overall rents then went down and the place ended up empty for 6 months. Which means it’ll take 8 years of the extra $50/mo before the 6 months of lost rent is accounted for (probably 12 if you count inflation).

Now the stories I hear from acquaintences — woah. One tenant decided to barbeque in his roof and set it on fire (all that nice tar on top)! He said after that, no more rentals — dividend ETFs for him.

19 db 06.01.07 at 3:29 pm

First of all, having read “Smart Women Finish Rich” and “Automatic Millionaire”, I too know that Bach isn’t talking about rental/income properties. He’s talking about your primary residence. Rental properties come later in his equation.

(And I do think his math is funny — and I think people tend to underestimate the impact of interest accrual on how much their mortgage really costs.)

I think rental/income properties CAN work out well for people, but that’s not guaranteed. For example, I inherited a rental property (that was also already in a lease-to-own contract) that has been nothing short of a nightmare. I’ve gotten a great education in having to constantly wrangle payments out of people and have gotten quite an education in what it would take to foreclose on a land installment contract. At the end of it all, the money we’ll get out of the deal won’t have been worth the amount of monthly oversight I’ve had to put into it. It’s been enough to make me swear off ever venturing into income properties for myself.

DB

20 db 06.01.07 at 3:35 pm

Oh, yeah — and my little inherited land installment contract is a $200/month rental property deal. Now you know somebody with one of those. It’s seriously frustrating to have to constantly deal with late payments and missed payments when the payment is $200/month. As I said before, the amount we’re getting from this isn’t worth the pain.

(Remember, I inherited both the property, the tenents and the existing land installment contract. None of it was my idea. And the property is in a depreciating rural town.)

21 MyOwnMillions 06.01.07 at 10:12 pm

I actually liked the book. I totally agree with your view of the miscalculations of his book but I like his relaxed and everyday type of writing style which should fit well with the average American.

I believe this book’s aim is to encourage people to save more and the automatic savings will probably help many americans “pay yourself first”. I guess it doesn’t deserve a whole book to have one main point but the book is worth it if it even helps a small percentage of people that read it.

22 Logan Flatt, CFA 06.02.07 at 10:23 pm

I am surprised that no one here including golbguru found the amazing error in David Bach’s example:

“If you invested $50,000 in a $250,000 home five years ago and it’s now worth $500,000, you’ve made $250,000 on a $50,000 investment. In investment circles, that’s called a five-bagger - an amazing 500% return on your money.”

That’s not correct. If you make a gain of $250,000 on a $50,000 investment your return is NOT 500% — it’s 400%. Check the math:

ROI = (Gain - Investment)/Investment

= ($250,000 - $50,000)/$50,000

= $200,000/$50,000

= 4 (or, 400%)

23 golbguru 06.03.07 at 8:26 pm

Logan Flatt: I have always followed this definition of rate of return (apparently David Bach did the same thing with this unfortunate numbers):

ROI = (Final Investment Value - Initial Investment Value)/Initial Investment Value

Which implies:

ROI = Gain (or Loss)/Initial Value

In that sense, for Bach’s calculation:

ROI = $250,000/$50,000 = 5 (or 500%)

Does that sound ok?

24 Logan Flatt, CFA 06.04.07 at 11:48 am

golbguru,

No, the definition of ROI is return on investment. That means Return / Investment. Return means that you got your initial investment back PLUS an additional amount (”the return”):

Return = Final Investment Value - Initial Investment Value

Ergo,

ROI = (Final Investment Value - Initial Investment Value) / Initial Investment Value

Or, by simplifying:

ROI = (Final Investment Value / Initial Investment Value) - 1

That means for the example given:

ROI = ($250K / $50K) - 1

= 4 (or, 400%).

25 golbguru 06.04.07 at 12:01 pm

Logan: Now I see what you mean. That’s what I meant when I said Bach misleads ;) - see he mislead the rest of us into believing that $250,000 is the *gain*.

Thanks for pointing it out.

In fact it’s hilarious the way he does it. I think the formula Bach is using (incorrectly) is:

ROI = (Final house value - Initial house value)/Down Payment

So, ROI = Gain in house value/Down Payment

Lol..that’s something new. :)

26 Andy 06.13.07 at 1:47 pm

You might check out “Safe Strategies for Financial Freedom,” by Van K. Tharp, D. R. Barton Jr., and Steve Sjuggerud. It covers saving, the stock & bond market, real estate, inflation — a really good all-around book.

27 Joe O 10.14.07 at 11:57 am

Quick correction for the discussion on ROI; the investment was a 5 bagger and did return 500%. The investment started as $50,000 and at the end was cashed out for $500,000 - $200,000 mortgage = $300,000. ROI = (300-50)/50 = 500%.

This simple logic, of course, leaves out the fact that if you actually sell it there would be listing fees, closing costs, etc. so your true net would be less than $250,000.

28 Logan Flatt, CFA 11.27.07 at 10:43 pm

Joe & Golbguru,

Wow. I think we’ve all — you, me, golbguru, and the author of the book — gotten this messed up “real good”, including me with my earlier comments above (being the finance professional in all this, I’d hope I’d know better).

First, a quick correction to Joe’s quick correction: a 500% return is not a “5 bagger” (insofar as I understand the hip and cool real estate guru phrases); instead, a 500% return would be a “6 bagger”. It is a 400% return that would be a “5 bagger”. Watch:

You invest $50 and double your money, ending up with $100 - presumably (since I generally don’t utter such cutesy financial phrases), a “2 bagger”. Your return would be: ROI = (100-50)/50 = 100%. It follows then, that:

“3 bagger” - 200%
“4 bagger” - 300%
“5 bagger” - 400%
“6 bagger” - 500%
ad nauseum.

So, if when you earn a “5 bagger” you earn 5 times your original investment, then you earn a 400% return on your investment:

Invest $50. End up with 5 times your investment: $250. ROI = (250-50)/50 = 400%.

Second, if the author above invested $50,000 (as Joe correctly pointed out, having borrowed the remaining $200,000 to complete his purchase) in a $250,000 home that five years later he sold for $500,000, he would — in very, very simplistic terms ignoring five years of interest paid on the mortgage, five years of maintenance & repair costs, five years of insurance premiums paid, five years of homeowners dues paid (if any), five years of property taxes paid, five years of heating/AC expenses (to keep it habitable while he lived in it), five years of principal payments paying down the mortgage, potential obsolescence of the property compared to newer properties built over the five years (could he have sold it for $550,000 otherwise?), the time value of money over those five years, five years of all other opportunity costs of his capital locked up in a relatively illiquid investment (real estate), and yes, expensive purchase and sale transaction costs (whew!) — have supposedly cleared $300,000 to himself after having paid off the $200,000 mortgage in full (not likely given the critically important cost caveats above, which notably the author apparently chose to simply ignore). So, in the author’s mind it looks like he actually made a “6 bagger”, having made six times his original investment (6 x $50,000 = $300,000). Ergo, his ROI would be 500%:

ROI = ($300,000 - $50,000)/$50,000 = 500%.

Clear as mud? :-)

Logan.

P.S. - Oooooo, look — the author actually is even further off: “If you invested $50,000 in a $250,000 home five years ago and it’s now worth $500,000, you’ve made $250,000 on a $50,000 investment.” In his example, he’s assuming that you don’t even sell the property — you still own it! So, you really haven’t cashed out or paid off the mortgage yet at all! You are still simply the owner of a house, with your $50,000 still locked up inside it, interest on the mortgage still accruing, expenses going out the door on heating/AC, homeowners dues, etc. So, it’s all “vapor gains” he’s talking about here. He says it’s “worth” $500,000 (to him), but what market price would he ultimately have to sell it to a willing buyer for? $450,000? $400,000? The actual sales price is critically important — just ask anyone in America today who is having to continuously lower their asking price to try and get out from under their adjustable rate mortgage before it resets — just like many others in their neighborhood are having to do.

P.S.S. - for a good (IMHO) commentary on some of the fallacies of “investing” in real estate, see my (simple too) article, “You Don’t Own Real Estate. Real Estate Owns You.”, at http://www.PowerWealth.com.

29 master tau 11.30.07 at 8:11 am

I think the author try to simplified as much as possible. People try to looks things at quite a negative way. The scenario ,”If you invested $50,000 in a $250,000 home five years ago and it’s now worth $500,000, you’ve made $250,000 on a $50,000 investment” …. He is talking about capital appreciation context only, not even add up the benefits of reduction in principal of the loan in those 5 years.
250k loan will produce monthly payment of US2,775.51 per month (Assuming he is taking 10 years loan and can rent it out at US1,500. Net Principal saving out of this after 5 years is Us46,339 (net ending equity after deducting interests). The actual return in the above scenario is US346,339. Initial investment outlay = 50,000 . US296,339/US50000 = 5.93 times .

30 Logan Flatt, CFA 12.01.07 at 1:37 pm

Master Tau,

My point is that the author (and now you) simplified too much so as to mislead general, layperson readers as to the true return available from the example “deal” and real estate investing in general.

With your additional information (a 10 year mortgage with a monthly loan payment exceeding the monthly gross income available from rental payments), you are suggesting that readers should take on a GUARANTEED negative cash flow property in the HOPE that a capital gain will somehow save the investment in 5 to 10 years hence. That is not investment — that is pure speculation and thus, gambling. Relying on an uncertain capital gain down the road while taking on a certain loss in cash flow today is completely foolhardy! No true investor would even consider such an “investment” in real estate.

Besides, engaging in such a “levered” situation is far too risky and therefore unsuitable for the average American. The risk of the average American ending up “under water” in a negative equity situation is rather high. The property need only lose $50,000 in market value for the mortgagee to get into real trouble.

In my view, an author hanging a shingle out as a finance professional or financial expert and then writing for a general audience should probably not advocate such “deals” as examples of how great real estate “investing” can be. At the very least, it introduces a moral dilemma for the author. Such an author should take care to expound on the risks of “investing” in such a situation especially when trying to sell books with catchy, emotion-grabbing titles to a general audience. Makes one wonder how many Americans could have been saved from taking out adjustable rate mortgages in an irrational market for “investment” real estate such as the one we have all witnessed over the past 5 or 6 years.

Logan.
http://www.PowerWealth.com

31 Sandy 12.19.07 at 7:56 am

You don’t have to invest in Real Estate yourself. You can find someone you trust who has a lot of experience and let them put your money to work for you and deal with all of the challenges. The term for this is Arm Chair Investing.

If you’re going to get in by yourself you need to educate yourself and be prepared for the risk. Certainly you can lose everything you put in if you don’t know what you’re doing and there’s quite a bit to know.

If you’re going to buy your own home, be just as educated about that. Don’t just buy a place you fall in love with if you want it to be an investment. Know the market, and if it works for you you can even get something that you can rent portions of for more than your mortgage.

The first house we bought we rented out the basement, the garage and one room. That gave us the start that took us from $100,000 of debt to become millionaires.

Yes, that million is available only if we sell the properties, yes we have dealt with tenant issues (now we use management companies to look after that), yes it took some work and sometimes there was and still is stress involved, but what is the alternative?

Should we have not got into Real Estate, be renters and hope government pentions are enough to pay our rent when we want to retire?

Our Real Estate makes us about $4,000/mo after expenses and that goes up every year. So does the value of the property. Remember, you’re going to have to subtract inflation from any gains you make so if you just invest in the market and make 7% or 8% you’re going to have to subtract the 3% - 5% inflation to know what you’re really going to be ahead by.

There’s a very simple recipe for financial success: Work as hard as you can, work as smart as you can (leveraged) and do it for as long as you can. I suggest the hardest work you do is working your way into work that you love. I happen to love real estate, but again, you can make money in real estate by letting someone else do all the “hard” work for you.

32 Serviced offices 10.31.08 at 6:17 am

Even ignoring the other real estate costs you listed above, I like stocks better. To get the same $ return with real estate in this example, you’ll need to purchase and run two rental properties. Twice the work and headache - and twice the time to manage. In addition, you’ll have to find a lender willing to finance you for 3 homes ( your primary residence and two rental properties ). Finding lenders to do that in today’s market will be *very* tough, unless you’re simply rolling in cash.

33 Puneet 02.18.09 at 1:53 pm

To find the true profitability on the ownership of a house, you should also add the rent savings that would occur during the period of home ownership. Here is the continuation of the example from David Bach . Assume I have put down 50K down towards a 250K house hence leveraging 5:1 ratio . After about 5 years, I sell the house for 300K and make 50K capital gains. I take your word for $58K in interest cost for these 5 years.

So here is the maths behind this investment

Profit - 50K
Rentals savings - assuming 1500 * 60 months (non tax deductible) - 90K
Deducting 58K on taxes in 5 years ( assuming 25% tax bracket) - 14500

total $$ after selling the house 50 K + 90K (hidden savings) + 14500 (deduction on int paid) -43500(int paid) = 111000

Also if you paid 5% to a real estate agent to sell the house which is .05 * 300K = 15000

You are still positive by 111K - 15K = 96K dollars
This is how real estate works ….

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