Real IRRs - Buy & Hold

[Ian Reynolds]

I see no compelling evidence that buy and hold forever can produce real returns on capital north of what can be had in equities markets with very few exceptions. Please try to poke holes in my arguments below. Id love to hear from investors who’ve held properties for more than 20+ years.

A true investment is one that allows cash to be returned to the investor at some period of time in the reasonable future. If you can never take the cash out, you are generating no real return.

• Many investors purchase buy and hold properties and calculate their returns based on:
  • The equity from loans paying down mortgages + appreciation
• Small amounts of cash from excess funds from rents
• In a stock by contrast, when I purchase that asset my appreciation is materially higher than my cash yield return. At a certain point, I will sell that asset and realize a gain.

Depreciation is a real expense

• · A number of investors in this forum have spoken of using deprecation to improve gains, but for long term buy and hold investing – deprecation of real assets constitutes a real expense. Floors, roofs, foundations, walls pipes, toilets, cabinets, fridges, water heaters, and utilities break down over time.
• · Deprecation is the amount of real capital that needs to be put back into the business in the future.
• · These are costs that must be factored into the portfolio over time.

Capital reserves cost money

• Capital reserves for a portfolio property are a drag on real returns. The cash may earn some degree of interest but it will be a drag against real performance.

Net real taxes are rising faster than rents and real wages

• · Real taxes are rising faster than rents; governments are incentivizing home ownership over rent seeking behavior. The result is that future cashflows will be smaller relative to taxes owed.

Equity appreciation and rising rents relative to the long term rise in equity values is poor when considering inflation.

• · Over a 30 year period, equities are certain to deliver returns averaging between 7-8%
  • o If I invest 10k into a broad based index fund I can sell it for ~76k after 30 years.
• o With inflation at 2% per year – real returns are closer to 5% pre-tax
• · Over a 30 year period if I can manage to get into a rental home just (breaking even) for 10k; which is going to be hard to do outside of the BRRR method my results are dismal.
  • o With inflation at 2% per year – my real return is flat.
• · If I depreciate the building I have to re-capture that when I sell and it hurts my returns.

Recapitalizations are certain to be more expensive in the future than they are today and risk the portfolio.

• · Interest rates have not been this low for 80 years, good luck repeating what can be achieved now with a cash out refi against assets that are inflated in price because of low rates.
• · Financing repairs is, therefore, going to be an expensive drag on returns
  
  

[Dan H.]

Originally posted by @Ian Reynolds:

I see no compelling evidence that buy and hold forever can produce real returns on capital north of what can be had in equities markets with very few exceptions. Please try to poke holes in my arguments below. Id love to hear from investors who’ve held properties for more than 20+ years.

A true investment is one that allows cash to be returned to the investor at some period of time in the reasonable future. If you can never take the cash out, you are generating no real return.

• Many investors purchase buy and hold properties and calculate their returns based on:
  • The equity from loans paying down mortgages + appreciation
• Small amounts of cash from excess funds from rents
• In a stock by contrast, when I purchase that asset my appreciation is materially higher than my cash yield return. At a certain point, I will sell that asset and realize a gain.

Depreciation is a real expense

• · A number of investors in this forum have spoken of using deprecation to improve gains, but for long term buy and hold investing – deprecation of real assets constitutes a real expense. Floors, roofs, foundations, walls pipes, toilets, cabinets, fridges, water heaters, and utilities break down over time.
• · Deprecation is the amount of real capital that needs to be put back into the business in the future.
• · These are costs that must be factored into the portfolio over time.

Capital reserves cost money

• Capital reserves for a portfolio property are a drag on real returns. The cash may earn some degree of interest but it will be a drag against real performance.

Net real taxes are rising faster than rents and real wages

• · Real taxes are rising faster than rents; governments are incentivizing home ownership over rent seeking behavior. The result is that future cashflows will be smaller relative to taxes owed.

Equity appreciation and rising rents relative to the long term rise in equity values is poor when considering inflation.

• · Over a 30 year period, equities are certain to deliver returns averaging between 7-8%
  • o If I invest 10k into a broad based index fund I can sell it for ~76k after 30 years.
• o With inflation at 2% per year – real returns are closer to 5% pre-tax
• · Over a 30 year period if I can manage to get into a rental home just (breaking even) for 10k; which is going to be hard to do outside of the BRRR method my results are dismal.
  • o With inflation at 2% per year – my real return is flat.
• · If I depreciate the building I have to re-capture that when I sell and it hurts my returns.

Recapitalizations are certain to be more expensive in the future than they are today and risk the portfolio.

• · Interest rates have not been this low for 80 years, good luck repeating what can be achieved now with a cash out refi against assets that are inflated in price because of low rates.
• · Financing repairs is, therefore, going to be an expensive drag on returns
  
  

 >In a stock by contrast, when I purchase that asset my appreciation is materially higher than my cash yield return. At a certain point, I will sell that asset and realize a gain.

In many RE markets this is also true. But when you add in the easy, low cost leverage of a financed RE assets I suspect this is true in all markets. Example, a RE market that is low appreciation such as 1%, achieves 5% appreciation on investment with an 80% LTV loan. In addition, in RE you can refinance (no need to sell) which would be slightly similar to a margin loan, but the refinance loan is much better terms than margin loans.

>Small amounts of cash from excess funds from rents

I am not sure if in either an initial high cash flow market or an appreciation market I would refer to this as a small amount of excess funds. In the initial cashflow markets the cash flow starts at a good return and maintains that return. In appreciation markets the cash flow starts poor, but improves with each rent increase. Statistics show that in year 8 to 10, most appreciation markets have matched the cash flow of the high initial cash flow markets. In both markets this cash flow at around this time is approaching the historical S&P but if you have financed the RE, the return is based on only having invested a fraction of the entire value. For example, assume 8% annual cash flow based on RE purchase value over a 10 year hold (whether it was the initial good cash flow market or the one that got there via rent appreciation does not matter) but realize with an 80% LTV loan you did not invest the purchase value but only 20% of the purchase value. This 8% cash flow now is 40% cash flow.

> Real taxes are rising faster than rents; governments are incentivizing home ownership over rent seeking behavior. The result is that future cashflows will be smaller relative to taxes owed.

This comment is very market specific.  In CA property raise slower than inflation and wages for a held property.

> Over a 30 year period, equities are certain to deliver returns averaging between 7-8%

Lets say RE goes up between 1% to 6% annually but you have purchased at 80% LTV. This means the property has gone up per invested amount 5% to 30% annually. The 5% is way behind the S&P500 lifetime average (approximately half), but the RE in that appreciation range are the RE that had good initial cash flow. They are chosen more for their cash flow than appreciation, so the appreciation is the icing on the cake. The one that goes up 6% year (think San Francisco type properties) have return 30% annually and by year 30 are having huge cash flow.

>Depreciation is a real expense

I agree with much of what you said about depreciation but will point out that many of the depreciation (cap expense) assets can be written off as maintenance.  For example, a hot water heater goes out with a tenant in the unit.  That is maintenance expense.  Sometimes that primary difference between maintenance and cap ex expense is if the unit is occupied.  So depreciating the entire value of the structure when many items can be fixed/replaced under maintenance implies that it is very difficult to really have that level of depreciation costs.  it is similar to being able to write off the repair costs in twice (once as maintenance out of the yearly profit and once with the depreciation).  I say this even though I suspect I believe cap ex/maintenance is significantly more costly than most LLs believe.

What I believe you are mostly not accounting for is the advantages of leverage to increase the return. The leverage is easy and cheap. At 80% LTV, the return is in effect 5X that return based on value.

I am a fan of both stocks/index funds and RE, but I would not do RE if my return was not astronomically higher than stocks/index funds. This is because stocks are much more passive than RE. Especially to optimize RE returns via value adds, BRRRR, etc. is not passive. Even just having traditional buy n hold RE is not passive.

If you want a solid return (S&P 500 lifetime approaches 10%) without much effort, an index fund is great.  If you want to achieve the highest return but with much more effort, RE provides that possibility.  I would not choose RE if I were only projecting 10% return or anywhere close to only 10% return (easy to just place the money in S&P 500 for similar return).

BTW, most of our RE are infinite return because after refi we had no investment in the RE.  Not saying it took zero effort, it takes effort and intelligence (more effort and intelligence than simply placing an investment in S&P 500 index fund).

Good luck with however you choose to invest.