Appreciation vs "Free" Equity?

Question

Hi Guys,

This is my first post to the Bigger Pockets forums and I'm at the beginning of my real estate journey with my current goal for 2017 being getting my first rental investment under my belt. My intent is to have a different vehicle that grows that is diversified from the typical 401k and IRA investments as well as giving me the ability to access that wealth through cash flow or liquidation of equity at a later point in time before retirement age. That being the case I'm looking at buy and hold rentals.

I am looking for some feedback on my thought process that I've yet to see people highlight. Using easy numbers in this hypothetical example, lets say I purchased a $100k property with a 10% down payment and a 30 year loan. Ideally you would have cash flow because you purchased it correctly, but for demonstration purposes lets assume the rent only covers taxes/mortgage, capital expenditures, property management, vacancies, etc with $0 left for cash flow (I know there's closing costs too, but lets assume its seller financed). Provided you purchased in a stable market and continued to keep up maintenance, your $10k turns into $100k if you sell after 30 years due to the renter covering your costs. Isn't that an annualized return of 30% ([$100k - $10k] / $10k * 100% / 30 years) ? Put a typical 20% down and the annualized returns in this example would be 13.3%, right?

As a long term buy and hold investor, is there a flaw in my thinking? I realize most discuss appreciation, but even with zero appreciation isn't the "free" equity still a solid investment? I want to be conservative with my first buy and have been thinking about increasing my down payment to 25% or 30% to ensure it cashflows positive. I realize that decreases the "cash on cash return" that many people here talk about. But if you begin to compound the cashflow with the equity at the end of 30 years aren't you still getting a solid return on your initial investment?

Welcome feedback to my thought process. I'll be looking in the Rochester, NY area as I'm located out in 315 territory (Wayne County) and am in the process of building my team of resources.

Regards,

Alan

Matthew Drouin · Answer

@Alan Smith I think you have the right train of thought.  I buy in very desireable neigborhoods and I don't bank on a ton of cash flow for my investment strategy.  In time your rents should grow conservatively and your cash flow should improve.  That being said, you should still buy your properties right and desire some cash flow.  Cash flow will act as a great buffer to a few bad months if you have them (think unexpected maintenance costs or unexpected vacancy loss.)  Our fund has a minimum required 11% cash on cash rate of return and a minimum 20% internal rate of return just to put things in perspective as to how we evaluate deals AND we buy in the best areas.  So in short; don't settle for break even.

Alan Smith · Answer

Everybody, thanks for the responses and feedback. Definitely some things to think about.

@James Swiech that makes sense from the perspective that $10k invested in a bond/mutual fund/stock would typically yield a return that first year and compounds thereafter so my math is too simple.

@Andrew Johnson I didn't want to ignore capital expenses either as for the roof example. My thought is that I'm still saving for those big expenses but even in the case where expenses equal income you're still not losing out at the end of the mortgage.

@Devin Deswert The point I was making with seller financing is that the closing costs weren't necessarily factored in like they would be with a typical mortgage.

Account Closed

Account Closed · Answer

If you are in a market of decent rent growth then each year your returns are even better than the 8%. And you also assume zero value growth. If you want zero appreciation you can get a lot better cash flow. If you take a cash flow neutral starting point, you usually get at least 2-3% increase per year. Now having 100K 30 years later is not the same as 100K today. With real inflation at 3-5% your real adjusted return is  only 5% or less.

Mike Cumbie · Answer

Hi Alan,

If I am understanding your question it boils down to you double your money over 30 years.

- You have zero cash flow

- You paid 100K and are selling for double 30 years later.

- The house paid for everything itself (taxes/insurance/cap ex/principal etc)

If that is the case you are making 2.34% a year on your investment. I would not consider that a solid investment.

Sorry if I am understanding it wrong

Good luck in your new business!

Michael Beinetti · Answer

@Alan Smith Hey friend!!!  Glad to see you here!  Very cool to see you are venturing into the investing realm.  Tons of great info here and amazing people (as you can clearly see by the responses!).

Talk soon!

Andrew Johnson · Answer

@Alan Smith You're 100% right that you wouldn't lose out at the end of the mortgage.  But if the roofing need came sooner than expected (let's say you bought a property built in 1990) you might not have the reserves built up from cash-flow to handle it.  Anyway, your original post was more theoretical but the real challenge with anything in real estate is applying it in a practical way.  Just ask anyone who has had a bad PM!

Leland Barrow · Answer

Personally I think every good real estate deal has a combination of equity, appreciation, and cash flow. If I am understanding correctly I think your question is can it be a good investment as just equity. That was answered already with a 'yes' and when considering the opportunity costs. Most investors try and buy below market value to get appreciation at purchase. This also jump starts the cash flow on the property. I like quality over quantity, so properties that outpace inflation with their appreciation, are under market value at purchase, and cashflow give the best IRR. I would not do an equity only model like you are suggesting because I do not see how it scales. Your cash is also locked up unless you sell. If the property does not appreciate then you cannot lock in gains until you sell the property. That is counter-intuitive to your stated goal.

The only thing in real estate that truly matters is the cash that you bring to the deal. Any deal that requires zero dollars or resources on your part and has any positive real return is a fantastic deal.

You want to turn 10K into 100k in 30 years and invest a significant amount of time to do that by renting a property. There is easier and faster ways to do that.

Sarah D. · Answer

@Alan Smith you should talk to a mortgage person to see what non-OO financing would require for s down payment. I'd suggest not just using a rule and getting other people to tell you the numbers; at that point you should consider turn key properties or REITs.  Take some time to learn your markets inside and out, and figure out what you need financially to get to your goals.

Matt Harris · Answer

In a perfect world yes makes sense but real estate and tenants are complete unknowns. Yes you can control location and screen tenants but no way will you have a perfect investment and tenant for 30 years.

Appreciation vs "Free" Equity?

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