Real Estate Investing – A Solution For The Destructive Accumulation Mindset
Why Real Estate?
Many of you are visiting this site to try to learn more about real estate investing. You may be surprised to learn that real estate actually has comparatively low immediately realizable returns relative to many other investing vehicles absent other attractive features. So why does real estate often rise to the top of the heap when it is compared to alternative forms of investing? In order to analyze the relative attractiveness of real estate it helps to list some of its properties:
1. Relative price stability in many areas of the country
2. Healthy net cash yields if done properly
3. Tax advantages
4. Ability to employ large amounts of leverage
5. Partial inflation hedge
No other investment offers all of the features listed better than real estate investing. Implemented properly, real estate investing can magnify cash flows appreciably and provide a vehicle to systematically replace active income that is earned with passive income that is managed. The real estate vehicle can also be used to convert accumulated financial wealth that looks great on paper into utilized cash flow that provides for financial independence to pursue and design the life of your dreams.
Optimizing Absolute Returns
As an investor you need to determine the optimal place to park your cash. There are as many different investment vehicles as there are ideas from creative and astute people that employ them.
In my humble opinion, the reason real estate is a superior investment vehicle is based on one’s ability to leverage the investment, translate gains into cash flows tax-free using the tax code, and eventually produce much larger cash flows.
Absent large absolute cash flows an individual will never have a short path toward financial freedom
Leverage
Leverage comes in many forms. The most immediate form of leverage that most people are familiar with are fully-amortizing term loans used to finance the acquisition of a piece of property. Let’s use a simple example to demonstrate the power of financial leverage. Suppose you purchase a median-priced home in the greater Austin, TX area for $200,000. You do not have the $200,000 to invest in the property so you get a non-owner-occupied, 60% LTV, acquisition loan from a mortgage broker in your area that will be amortized over 30 years at 7% interest. In order to calculate your loan payments you can use the following formula for an ordinary annuity:
R = P / {[(1 – 1/(1 + i)^n] / i}
Where R = the periodic payment in an annuity (the amortized payment)
P = the principal (or present value)
i = The annual interest rate
n = The number of years for the annuity (30 years = 360 months)
So in our example the present value, P, would be 60% of $200,000, or $120,000. $120,000 would yield principal and interest payments of:
R = $120,000 / {[1 - (1 / (1 + (0.07 / 12))^360)] / (0.07 / 12)}
R = $798.36
Let’s say that the property will lease for $1700/month in the area that this property resides. Let’s also assume that this property requires an average amount of maintenance and capital improvements and has rents set properly to yield a 5% vacancy expense. We will also assume that a management company deals with the day-to-day hassles of managing the property. All of these expenses consume roughly 45% of the gross rental revenue to yield a net operating income of $935. After our debt service payment of $798.36 we are left over with $136.64 of cash flow after we fund accounts to cover vacancy, capital, and other operating expenses.
If you take a closer look at this analysis you will find that $1639.68 of annual freely available cash flow against an initial cash outlay of $80,000 yields a cash yield of roughly 2%. This is hardly anything to write home about. Why is this so exciting then? Have we failed to address important items in our analysis or does this line of reasoning prove that real estate has cash yields similar, or inferior to, other investment vehicles? In order to address this question properly we need to analyze other elements of the overall real estate return and scrutinize what component expenses contribute the largest amount to our overall property-related expenses.
Additional Real Estate Return Drivers
We have spent a great deal of effort reliably and conservatively defining the frequently used, but often ill-defined cash flow component of real estate. We have not addressed any of the following components:
1. Appreciation
2. Amortization (assuming you use debt to finance the purchase)
3. Tax advantages
If we ignore the components above we fail to capture a great deal of the overall real estate return. In my experience the reason these figures are not tossed around as loosely as cash flow is because they are highly deal and investor centric. Appreciation varies widely around the country and is largely driven by a scarcity of available land to build on or an unfavorable environment for builders. The amortization component depends a great deal on the type of debt product you use for the acquisition. Taxes shields are horrendously complex and subject to phase out if your income rises appreciably or if you already have substantial income.
Having addressed the fact that an ultimate analysis depends largely on the investor, I will attempt to demonstrate some general thoughts about the other real estate return drivers. If you want to do what securities dealers do and take the average appreciation rate of real estate all over the United States in the last 50 years you will find that the average appreciation rate is around 6.3% in nominal terms. Let’s be conservative and use a nice round 6% appreciation rate that generally outpaces inflation by 3%. In our example above that would mean the property would appreciate $200,000 * .06 = $12,000. Sure, there will likely be credit-constrained or unfavorable years where your property value stays the same or decreases. What we are claiming in our example is that if you hold the property for a “long time” it will likely appreciate on the order of 6% annually. $12,000 on an initial investment of $80,000 is a nice 15% leveraged return at 60% LTV.
In our example we also used a 30 year note to calculate our monthly debt service. Using an amortization table we see that $1,218.97 out of $798.36 * 12 months = $9580.36 in annual payments goes toward principal reduction. $1218.97 on an initial investment of $80,000 is a 1.5% return in year 1. Note that this percentage increases appreciably in the later years of a loan. We won’t worry ourselves with these later year returns too much though because we will see later that it makes more sense from a ROE perspective to leave our investment leveraged.
Taxes quickly get horrendously complex and will likely continue to follow this trend as long as the electorate allows our legislators to tinker with the tax structure during every new regime in Washington. Let’s arbitrarily assume that your marginal tax return is 10%, a nice conservative number that will hopefully keep skeptics from claiming that our end result is largely a function of fickle tax shields. You will also need to make an assumption about the investor’s taxable income less the tax shield afforded by a 27.5 year straight-line depreciation schedule. Let’s use $100,000 in annual income to make the arithmetic easy in our example. Further, let’s assume that personal property will not be accelerated using a chattel appraisal or cost segregation study and that the investor gains no dual-use write-offs as a result of their first property purchase. Using these elementary assumptions the investor would see a $100,000/27.5years = $3,636 in annual tax shields. This tax shield would yield $364 (rounded) in annual tax savings with a 10% marginal tax rate. $364/$80,000 is less than a 1% yield, but we will round up to make the numbers cozy and to carry the tax component in our overall analysis below.
Summing our individual components we see that an investor could see a:
2% cash-on-cash return
+ 15% capital gain on appreciation
+ 1.5% capital gain on note amortization
+ 1.0% cash-on-cash return on tax savings in the next tax year
= 19.5% (leveraged)
This result is simplistic and does not account for the time value of money in later years or timing of actual cash flows. A more precise definition of return would account for the actual timing of cash flows and translate the return into a Realized Compound Yield. The intention of this example is not to give an ironclad process for evaluating real estate returns. The intention is to demonstrate return drivers, the power of having 4 separate profit centers with real estate, and the ultimate power of leveraging.
So what does this all mean? It is fantastic to have a 19.5% return in year one, but what does that do for me? I can’t spend the equity you say. In order to unleash the true power of real estate you have to translate that accumulated wealth into utilized cash flow to make incremental steps toward financial freedom. In later years an investor can 1031 exchange capital gains on property into larger properties which will translate those gains into more fungible cash flows that can replace larger portions of daily expenses and help to build a ladder toward financial freedom. Paper equity serves no tangible purpose for someone trying to design a life of their choosing. Accumulated paper equity also saps return on equity in projects, as we will see in later articles.
We will explore these ideas in more detail in the next article I write about multi-family investments.
Many of you are visiting this site to try to learn more about real estate investing. You may be surprised to learn that real estate actually has comparatively low immediately realizable returns relative to many other investing vehicles absent other attractive features. So why does real estate often rise to the top of the heap when it is compared to alternative forms of investing? In order to analyze the relative attractiveness of real estate it helps to list some of its properties:
1. Relative price stability in many areas of the country
2. Healthy net cash yields if done properly
3. Tax advantages
4. Ability to employ large amounts of leverage
5. Partial inflation hedge
No other investment offers all of the features listed better than real estate investing. Implemented properly, real estate investing can magnify cash flows appreciably and provide a vehicle to systematically replace active income that is earned with passive income that is managed. The real estate vehicle can also be used to convert accumulated financial wealth that looks great on paper into utilized cash flow that provides for financial independence to pursue and design the life of your dreams.
Optimizing Absolute Returns
As an investor you need to determine the optimal place to park your cash. There are as many different investment vehicles as there are ideas from creative and astute people that employ them.
In my humble opinion, the reason real estate is a superior investment vehicle is based on one’s ability to leverage the investment, translate gains into cash flows tax-free using the tax code, and eventually produce much larger cash flows.
Absent large absolute cash flows an individual will never have a short path toward financial freedom
Leverage
Leverage comes in many forms. The most immediate form of leverage that most people are familiar with are fully-amortizing term loans used to finance the acquisition of a piece of property. Let’s use a simple example to demonstrate the power of financial leverage. Suppose you purchase a median-priced home in the greater Austin, TX area for $200,000. You do not have the $200,000 to invest in the property so you get a non-owner-occupied, 60% LTV, acquisition loan from a mortgage broker in your area that will be amortized over 30 years at 7% interest. In order to calculate your loan payments you can use the following formula for an ordinary annuity:
R = P / {[(1 – 1/(1 + i)^n] / i}
Where R = the periodic payment in an annuity (the amortized payment)
P = the principal (or present value)
i = The annual interest rate
n = The number of years for the annuity (30 years = 360 months)
So in our example the present value, P, would be 60% of $200,000, or $120,000. $120,000 would yield principal and interest payments of:
R = $120,000 / {[1 - (1 / (1 + (0.07 / 12))^360)] / (0.07 / 12)}
R = $798.36
Let’s say that the property will lease for $1700/month in the area that this property resides. Let’s also assume that this property requires an average amount of maintenance and capital improvements and has rents set properly to yield a 5% vacancy expense. We will also assume that a management company deals with the day-to-day hassles of managing the property. All of these expenses consume roughly 45% of the gross rental revenue to yield a net operating income of $935. After our debt service payment of $798.36 we are left over with $136.64 of cash flow after we fund accounts to cover vacancy, capital, and other operating expenses.
If you take a closer look at this analysis you will find that $1639.68 of annual freely available cash flow against an initial cash outlay of $80,000 yields a cash yield of roughly 2%. This is hardly anything to write home about. Why is this so exciting then? Have we failed to address important items in our analysis or does this line of reasoning prove that real estate has cash yields similar, or inferior to, other investment vehicles? In order to address this question properly we need to analyze other elements of the overall real estate return and scrutinize what component expenses contribute the largest amount to our overall property-related expenses.
Additional Real Estate Return Drivers
We have spent a great deal of effort reliably and conservatively defining the frequently used, but often ill-defined cash flow component of real estate. We have not addressed any of the following components:
1. Appreciation
2. Amortization (assuming you use debt to finance the purchase)
3. Tax advantages
If we ignore the components above we fail to capture a great deal of the overall real estate return. In my experience the reason these figures are not tossed around as loosely as cash flow is because they are highly deal and investor centric. Appreciation varies widely around the country and is largely driven by a scarcity of available land to build on or an unfavorable environment for builders. The amortization component depends a great deal on the type of debt product you use for the acquisition. Taxes shields are horrendously complex and subject to phase out if your income rises appreciably or if you already have substantial income.
Having addressed the fact that an ultimate analysis depends largely on the investor, I will attempt to demonstrate some general thoughts about the other real estate return drivers. If you want to do what securities dealers do and take the average appreciation rate of real estate all over the United States in the last 50 years you will find that the average appreciation rate is around 6.3% in nominal terms. Let’s be conservative and use a nice round 6% appreciation rate that generally outpaces inflation by 3%. In our example above that would mean the property would appreciate $200,000 * .06 = $12,000. Sure, there will likely be credit-constrained or unfavorable years where your property value stays the same or decreases. What we are claiming in our example is that if you hold the property for a “long time” it will likely appreciate on the order of 6% annually. $12,000 on an initial investment of $80,000 is a nice 15% leveraged return at 60% LTV.
In our example we also used a 30 year note to calculate our monthly debt service. Using an amortization table we see that $1,218.97 out of $798.36 * 12 months = $9580.36 in annual payments goes toward principal reduction. $1218.97 on an initial investment of $80,000 is a 1.5% return in year 1. Note that this percentage increases appreciably in the later years of a loan. We won’t worry ourselves with these later year returns too much though because we will see later that it makes more sense from a ROE perspective to leave our investment leveraged.
Taxes quickly get horrendously complex and will likely continue to follow this trend as long as the electorate allows our legislators to tinker with the tax structure during every new regime in Washington. Let’s arbitrarily assume that your marginal tax return is 10%, a nice conservative number that will hopefully keep skeptics from claiming that our end result is largely a function of fickle tax shields. You will also need to make an assumption about the investor’s taxable income less the tax shield afforded by a 27.5 year straight-line depreciation schedule. Let’s use $100,000 in annual income to make the arithmetic easy in our example. Further, let’s assume that personal property will not be accelerated using a chattel appraisal or cost segregation study and that the investor gains no dual-use write-offs as a result of their first property purchase. Using these elementary assumptions the investor would see a $100,000/27.5years = $3,636 in annual tax shields. This tax shield would yield $364 (rounded) in annual tax savings with a 10% marginal tax rate. $364/$80,000 is less than a 1% yield, but we will round up to make the numbers cozy and to carry the tax component in our overall analysis below.
Summing our individual components we see that an investor could see a:
2% cash-on-cash return
+ 15% capital gain on appreciation
+ 1.5% capital gain on note amortization
+ 1.0% cash-on-cash return on tax savings in the next tax year
= 19.5% (leveraged)
This result is simplistic and does not account for the time value of money in later years or timing of actual cash flows. A more precise definition of return would account for the actual timing of cash flows and translate the return into a Realized Compound Yield. The intention of this example is not to give an ironclad process for evaluating real estate returns. The intention is to demonstrate return drivers, the power of having 4 separate profit centers with real estate, and the ultimate power of leveraging.
So what does this all mean? It is fantastic to have a 19.5% return in year one, but what does that do for me? I can’t spend the equity you say. In order to unleash the true power of real estate you have to translate that accumulated wealth into utilized cash flow to make incremental steps toward financial freedom. In later years an investor can 1031 exchange capital gains on property into larger properties which will translate those gains into more fungible cash flows that can replace larger portions of daily expenses and help to build a ladder toward financial freedom. Paper equity serves no tangible purpose for someone trying to design a life of their choosing. Accumulated paper equity also saps return on equity in projects, as we will see in later articles.
We will explore these ideas in more detail in the next article I write about multi-family investments.
Comments (5)
So no cashflowing property Don? Not a big believer? What do you loan on?
Bryan Hancock, over 14 years ago
I divide my portfolio into two parts, high yield short term loans for income and discounted property for appreciation. Good article.
Don Konipol, over 14 years ago
By having a good mix of cash flow as well as appreciation can add value to any property. In addition, by increasing the value of the property your return at sale time increases exponentially!
Dale Osborn, over 14 years ago
Agreed Charles...I got tickled reading the "Cash Flow Versus Appreciation - Clash of the Titans" thread...I even sent it to my coaching clients so that they could read it. You can love cash flow all you want, but unless your leverage and/or debt constant is really low you won't get too much cash flow with SFRs. The bulk of the gains will be with appreciation. This is largely a function of owner-occupants bidding up prices beyond what a rational investor would pay. Consequently, you have to bid against those same "investors" to purchase property. That value may be fickle, but it is still REAL. My next installment for this series will highlight how to exchange SFRs to MFDs via a 1031 exchange to pop cash yields and monetize spendable cash flow to live on. That is the goal of almost every investor I know so it is something people should have a better road map for IMO.
Bryan Hancock, over 14 years ago
Real estate appreciation can be huge. I have been investing for 15 years, my wife for nearly 30 years. We have bought and held onto a number of properties that have seen significant gains over the years. One property purchased by my wife in 1980 for $25,000 is valued at $500,000 even with the adjustment created by the housing bubble. Cash flow is important, but appreciation is important as well.
Account Closed, over 14 years ago