Richard sent me an e-mail [ajc AT 7million7years DOT com] asking:
I have read through most of your past posts. 2 questions come to my mind. Hope you can clarify.
1) You always tag a 30% return for real estate. If one puts 20% down on a prop and add in all the closing costs, capital up front will be like 25%. Assuming a 6% capital appreciation like you like to use, I don’t see how you can come out with 30% return on capital. My assumption is that we breakeven on cash flows. I did the calculation a while back and I think 15% is about the max.
2) I read that you have sold off your commercial properties and are looking to get back in. Why do you sell it of if real estate investing is for the long term? Can’t you refinance to tap into the equity and use it for other investments? Why do you want to “time” the market? Transaction costs are heavy in RE.
Let’s deal with the first part of the questions first: 30% is a very hard ask for any traditional investment, let alone real-estate. But, it can be done … if you’re a highly geared and successful [read: lucky] property developer.
More typical maximum investment returns can be seen in the following table:
By putting Franchises into this table – which many would consider more business than investment (but, I treat as an investment IF you can be an absentee-owner and acquire multiple franchises under the franchisor’s rules) I guess that I’m framing that you need to do a lot more than simply buy your own home and pay off your own mortgage to get these kinds of returns.
Real-Estate sits in the middle of this part of the growth table and, I agree with Richard, is probably closer to the 15% compound growth rate end than 30%.
But, the key question is: how does this kind of growth occur?
It occurs because of leverage:
1. Financial leverage – You can use the bank’s money to gain a ‘free additional compound return’. Here’s how it might work:
You put 20% (or $20k) down on a house that costs $100,000 (ignoring closing costs for the sale of simplicity).
IF property only increased by 6% per annum, as Richard suggests (it’s actually a historical, US-wide growth rate quoted by a number of analysts in the past), and mortgage rates are around 4%, then the house will increase in value by $6k, but your mortgage will cost you $4k (actually, only 80% of that, since you put in $20k cash). Fortunately, this is a rental, so let’s say that you earn another $4k (4%) in rent.
Your total return is $6k, which doesn’t sound like a lot for a $100k asset (but DOES sound like Richard’s 6%), but you forgot one thing: you didn’t put in $100k … you only put in $20k, which you have just grown to $26k (in some mix of cash and/or equity) which is an ‘easy’ 30% return.
Now, you may not have picked this up, but who said that you needed to put down 20%? If the bank, fair enough …
… but, what if the bank allowed you to go with 10% (or, $10,000) down? Then your return almost doubles.
Even so, because real-estate is rarely cash-flow positive in the early years and appreciation isn’t always all that you expect, you need to add other kinds of leverage.
Here are some examples:
2. Knowledge leverage: If 6% is the average increase in home values across the entire country, do you think that you may be able to do better with a little research? For example, could you choose an urban area rather than a rural area (urban areas typically grow faster than average, and rural areas grow less)? Could you choose an upcoming neighborhood to invest in (one with lots of new families moving in, rather than one with an aging population where people are moving out)? Could you choose a high-demand location (one near a beach, near a park, near transport, near schools, near a mall, and so on) rather than one near factories and warehouses?
3. Value-added leverage: Could you take the least-loved house in the street and add value by: adding a bedroom? Painting the house? Cleaning up the garden? Upgrading the kitchen and bathrooms?
4. Opportunity leverage: could you find a house that nobody wants and buy it at a discount before it even comes onto the market? Could you find a poorly managed rental and be a little more hands-on in terms of looking after the property and tenants in order to increase rents over time?
Any ONE of these factors could positively influence your compound growth rate well over the averages. Combining as many of these factors as possible could positively hit your real-estate returns our of the ball-park.
As to the second part of Richard’s question, he is quite correct: buying real-estate and holding for the long-term is usually the right strategy.
However, circumstances may arise where that strategy does not make sense: e.g. I owned my office building, but once the business was bought and the tenants (my former company) moved out, I didn’t want to hold the commercial property while I was overseas and look for tenants.
In hindsight, I should have kept it.