Zero Coupon Rentals

By Michael Douville - Real Estate Market

In this day and age of complex derivative instruments and acronyms to boot, I've created a financial security of my own, the "Zero Coupon Rental" (ZCR).

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Zero coupon bonds are sold at deep discount and generate no cash flow. The interest earnings are compounded and embedded into the price of the bond. An investor can purchase the instrument with a one-time expenditure and allow the investment to grow over a long time frame: typically 10, 15, 20 or 25 years. The longer the time frame, the deeper the discount, and the higher the anticipated future return.

Zero coupon bonds are loved by planners, who use them when a known event will require funds. These events are generally many years in the future and require some planning. College educations and retirement are the typical uses, but any long-term goal fits, such as say a business start up for a college graduate or the wedding of dreams. Zero coupons work great for potential needs.

Every worker, whether employed or self-employed, needs to consider their retirement needs. The earlier provisions for retirement are started, or a fiscal strategy is begun, the more assets will be accumulated and the sooner financial independence will be achieved. One wealth strategy that I have employed with income rich investors, I like to call the "Zero Coupon Rental". The simple steps to employ the strategy are as follows:

1. Identify the universe of properties suited for the market segment that has been targeted for acquisition. This is usually a family home typically 3 or 4 bedrooms, 2 or more bathrooms, at least a 2 car garage, a fenced backyard, and in the 1500-1800 sq. ft range. However, there are other choices including college shared units, singles lofts, corporate and vacation furnished rentals, horse properties, farms, etc... The main ingredient is the need for the investor to familiarize themselves with the potential investment, and immerse themselves in the details of the neighborhood, such as schools, shopping, transportation, demographic make up, and historical growth of rents and appreciation. When researching the neighborhood, pricing of the properties will become apparent, and a short study will provide the knowledge necessary to recognize a market "anomaly." This anomaly usually comes in the form of a very good property at a discount to market. This discount would likely be caused by a pricing mistake or a distress-motivated seller. At the moment, the market is rich with the distress of REO Foreclosures.
2. Purchase the property at a discount. Even a discount of as little as 5% will boost the total return. In today's, environment the REO's are being offered aggressively to the market, and non-foreclosed properties are forced to compete on price. The result is an opportunity that is available once every twenty or so years.
3. Leverage the property to a level sufficient to generate break-even cash flow. In other words, use as little down payment as possible to equalize the rent and the debt service, taxes, insurance, repairs, leasing costs, vacancy factors, etc. Depending on the investment, this could be from 10-30% down payment; mortgage the balance with a 30-year fixed rate loan. Long-term rates are terrific in the 6-6.5% range as of today.
4. Upon closing, you have created an investment with a guaranteed return. Anyone with children will attest to how quickly 10, 20, or 30 years can pass. The tenants who occupy the rental will pay the balance of the mortgage off in 30 years. The mortgage payment will remain reasonably constant over the life of the loan, varying by taxes and insurance, HOA fees, etc. However, the rent will not. Rent increases over time. The typical rent increase is 3-5%; some years are less, but rents have been depressed for years, and a10-15% increase is possible after the glut has been absorbed. Many individuals are not interested in additional cash flow during their high earning years, and so the rent increases should be used in a principal reduction strategy to reduce the mortgage balance to zero. Obviously, increasing the principal reduction of a fixed rate mortgage by an additional 3-5% each year will reduce the payoff time from 30 years to 18, 16, or even less.
5. The rental income then pays the loan off in a prescribed time and may be accelerated at the investor's option. Only one cash investment is needed and the property becomes self-sufficient. Purchasing multiple properties and tailoring the loan payoffs to meet future needs, allows for incredible wealth generation and long range planning.
6. A typical scenario involves accumulating 10 properties over a 10-year period. For the sake of simplicity, a non-appreciating environment is assumed. Assume also a $300,000 purchase price with a 20% down payment and an additional $5,000 in costs. A yearly investment of $65,000, excluding any capital gains or tax benefits would result in 10 free and clear properties within 20 years. $650,000 would grow to $3,000,000 if there was absolutely NO appreciation, and it would result in huge cash flow even if there was NO growth for 20 years. The demographics of the US are so compelling as to make that possibility near to impossible.

In conclusion, asset markets always offer opportunities. Sometimes it is the stock market, sometimes it is the bond market; recently it has been the commodity market. The global market is at an inflection point, and money is moving out of the richly priced oil and commodity sectors and into undervalued groups like financials and real estate. A shift is taking place, and in my view, in 18-24 months those that repositioned their portfolios to reflect the change should be richly rewarded.

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