In A Brief History of Time, Stephen Hawking refers to a publisher’s rule of thumb that states that every formula that a writer includes in a publications will cut his readership in half. Well real estate investing is based on relatively simple principles - especially next to the stuff that Hawking researches- but there are some RE investing concepts that can be communicated a bit more effectively aided by a few equations and numerical examples. So bear with me - with this post I'm going to crawl through some numbers and risk turning off a few readers...
I mentioned in a recent column that when real estate investment starts “getting good” – when it starts generating some cash and putting some dollars in your pocket on a monthly basis – then that’s when it's time to sell. This might sound counter-intuitive, but let me give some examples that show why it is true.
Based on simple price appreciation, the stock market beats real estate hands down. Over the past twenty years or so the S&P 500 has gone up at an average rate of almost 10 percent per annum. The NASDAQ has appreciated at over over 11 percent per anum. Over the same period the average single family home in America has appreciated at around 5.6 percent. So why do we get so excited about real estate? Because it allows investors to prudently use leverage to increase her returns. And why should we consider selling a property just when it starts kicking off cash? Well, that's because this is a good sign that your leverage is running out of steam.
Consider a simple example. An investor puts 20% down on a $100,000 property. The investor starts out with $20,000 equity on a $100,000 house, giving him 5-to-1 leverage. Meaning: if the house appreciates by 5% that's $5,000 - a 25% return on the initial $20,000 investment. This is a basic concept you’re probably familiar with.
As time passes by two things will probably (hopefully) happen: a) the property will go up in value (a good thing) and b) your loan balance will decrease (also a good thing). But there’s an unintended by-product: a decrease in your leverage.
The diagram assumes an 8% fixed rate mortgage and an annual appreciation rate of 4.5%. Note that this isn’t a bad investment – in 15 years the initial $20,000 produces over $120,000 in equity. That’s an annualized rate of return of about 14%, which is considerably better than you'd expect out of the stock market over the same duration. But consider what happens to leverage (right axis). By year 5 around $4,000 will be paid off of the loan. And assuming that 4.5% appreciation rate, the property will have increased in value by around $24,000. That adds a total of $28,000 to the equity in the property – so now there is $48,000 tied up in the house.
In summary:
- Initial leverage: $100,000 property ÷ $20,000 equity = 5 to 1 leverage
- Five years later: $124,000 property ÷ $48,000 equity = 2.6 to 1 leverage
But, there is another strategy that will allow investors to considerably increase their returns over the long run wil acceptable risk. Read more to find out how...
Related links
;)
;)
