Cost burden of appreciation

[Marc Zak]

In the market where I live (San Diego), appreciation has been strong and many predict it will continue to appreciate in the long term.

However, with current interest rates (6% at best) and property tax (2%), the annual cost burden is 8%.

Am I correct in saying that appreciation has to be above 8% annually (plus whatever my maintenance and vacancy costs are) for me to make any money in this scenario if the property is cash flow neutral? This seems unlikely in the long run.

[Dan H.]

Quote from @Marc Zak:

In the market where I live (San Diego), appreciation has been strong and many predict it will continue to appreciate in the long term.

However, with current interest rates (6% at best) and property tax (2%), the annual cost burden is 8%.

Am I correct in saying that appreciation has to be above 8% annually (plus whatever my maintenance and vacancy costs are) for me to make any money in this scenario if the property is cash flow neutral? This seems unlikely in the long run.

Your not correct under many different circumstances.

First property tax is 1.1% (fairly safe) with 2% annual increase (prop 13).

Next expenses include a lot more than property tax and interest.  Maintenance/cap ex, insurance, if a rental PM, bookkeeping, misc.

The fact you have a loan means 1) leverage 2) equity pay down.

In addition, there are tax benefits.

So I will do some rough underwriting as an OO non-rental at 95% LTV (because FHA has some undesired consequences that make the 1.5% difference in LTV worth avoiding the FHA).

equity paydown: 20% (using OP interest rate at 95% LTV and not counting closing costs).  lets call it 15% allocating for closing costs.

Appreciation multiplier due to leverage 20X if not counting closing costs.  As a percentage closing cost as percentage goes down as value increases but we will 15X to account for closing costs
No cash flow per OP.

2% market appreciation equated to 30% + 15% = 45%
3% market appreciation equates to 45% + 15% = 60%
4% market appreciation equates to 60% + 15% = 75%

Recognize in virtually all markets the cash flow increases with hold length especially if a fixed rate loan.  The P&I will be fixed.  In San Diego the property tax is near fixed.  This means that the bulk of the expenses are not going up annually.

In addition, if OO you get to write off the property tax and interest to the SALT limit ($10K).  So if you are in a 30% combined tax bracket you get an additional $3K due to write offs.

If it is a rental, you can write off the business expenses and the depreciation on the non land valuation.  In addition you can accelerate the depreciaiton.  I have gotten accelerated depreciation that has exceeded my initial investment.

Now add that you could perform a value add to create some sweat equity.  You could also purchase below market value.  If you can rehab and refinance (BRRRR) to extract all investment and achieve neutral cash flow you would have infinite return (most of my RE investments have achieved infinite return but the cash neutral has in particular gotten a lot more challenging when the rates rose starting Q2 of 2022).

Any money extracted via a refinance is tax deferred.  For OO owning it for 2 years of 5 gets $250K gains per spouse of tax free gain.  If you die while holding the property, it gets a stepped up value and all the gain is tax free.

If rental the taxes can be deferred via a 1031 and if you die while holding it, it gets the stepped up bases with gain forgiven.

Hopefully the numbers provide some example of possibilities.  There are a lot of possibilities and a lot of ways to make money in RE.  However, I do not want to make the possibilities seem simple.  The interest rate increase has made it much more challenging to find good RE investment opportunities in San Diego (I have not purchased in 3 years in San Diego).

Good luck