The Perils of The 50% Rule Myopia

The rhetoric about the 50% rule of thumb has died down on the board recently so I thought it may be time to have a more rational discussion about the belief that you can summarily dismiss the other 3 major profit centers in real estate.  I have other blog posts about the key return drivers and how appreciation is a major driver of total return on investment for real estate projects.  This position has been parroted by many of the most successful investors I have been fortunate enough to meet in my brief real estate career.  I hope to one day emulate their success; hopefully to a greater degree.

Rehashing these same points about appreciation doesn’t really interest me a lot in this post.  Instead I want to focus on the two other profit centers that have been the source of criticism on the board of late. 

The first of these items is what is colloquially known as a “tax shelter.”  The argument is made that if you are fortunate enough to benefit from a tax loss on a property then it is a poor investment to begin with.  This line of reasoning ignores the obvious phantom loss of depreciation and also those items which can be categorized as “dual use” items from a business and personal perspective.  The typical counter to this point is that recapture taxation taketh what the ephemeral depreciation giveth.  This argument may be more compelling if there wasn’t a built-in strategy for dealing with the problem with 1031 like-kind exchanges and a stepped up basis at the time of death.  Proper tax planning and knowing the rules makes these phantom tax shields both real and an important component of the overall returns attributable to investing in real estate.

The other key element of real estate investing that receives virtually ZERO press is the amortization of the loan principal balance.  My personal observation about this reveals that it is almost completely ignored because of its distant realization.  Real estate investors live in a get-rich-quick, fire your boss, unicorns and fairies world constructed by quasi criminal guru personalities.  Naturally this type of charlatan-laden environment attracts those focused on the immediate financial prize.  These folks don’t care that someone else is paying down a mortgage for them and they will one day enjoy a nice golden nest egg that spits off cash in current dollars.  Who cares that that fixed-rate debt is denominated in money that has long-since been devalued by unsound monetary policy?  Who cares that the steep part of the amortization curve doesn’t last forever?  All that these folks care about is money in the bank today to feed their need to show everyone how successful they are!

In order to properly analyze an investment ALL FOUR of the return metrics need to be accounted for.  Disregard the comments on the board that discount the value of the other components in favor of a cash-flow-centric, 50% rule of thumb worship session.   Cash flow is great, but so are the other drivers of real estate profits.