Congrats…Your Market is HOT! (What Does That Really Mean For Your Investment Returns?)

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Beginning in 2013, long term real estate investors all over the country found an investing landscape that was vastly different from the post-recession period. Markets went from a state of stagnant hibernation to one of explosive internal combustion almost “overnight.”  From vast inventories of distressed bank and government foreclosures to tight inventories, multiple offers and bidding wars. Inevitably, a critical question arises:

What’s the impact of an appreciating market on real estate investment returns?

What happens to returns in an environment of rising prices?

At first glance, this may seem like a question for Captain Obvious, but there’s a lot more to it than you think. In physics, the Law of Conservation of Energy says that energy cannot be created or destroyed – it just changes from one form to another. What happens to  your investment returns in an appreciating market follows a similar template.

From a cashflow perspective, when you pay more for the same income stream, your return from cashflow goes down. That’s elementary enough, but does it tell the whole story? Let’s put some pen to paper and see what the numbers have to say about this.

To start the analysis, let’s look at an investment property in a good location, zoned to good schools with nice finishes that you can purchase for $160,000 that will rent for $1650 per month with 40% operating expenses, vacancy and leasing fees. Assuming financing with 20% down at 5% interest, the annual positive cashflow is $3,629 which translates to about a 10.2% cash on cash return on your $35,000 cash investment. Now, if you were to pay 10% more for the property (or $176,000) with everything else remaining equal, your positive cashflow drops to $2804 as the cost of servicing the mortgage rises with the higher loan amount while your cash investment increases to $38,200 reducing your cash on cash return down to 7%. So, if your required threshold return on investment is 10% or higher, you would do the first deal but not the second. Right?

Except that in my experience, most investors don’t know how to properly calculate the return on an investment property. It turns out, the cash on cash return gives nothing more than a myopic snapshot of the cashflow return during the first year. It neglects to account for returns that come from mortgage paydown, rent increases and value increases during the holding period. A long term real estate investor always begins with the end in mind and looks at the performance of the investment over the entire period she owns the property.

Related: Should You Stop Buying Real Estate in a Appreciating Market? I’m Still Buying and Here’s Why

MIP 160k No Appreciation
Purchase price of 160k – No Appreciation
What you’re looking at above is essentially a projected X-Ray of an investment from acquisition to exit. At year 0 (acquisition) you invest $35,000 to make the purchase, followed by cashflows over the next 10 years and finally the return of the capital at the sale. The assumptions I made in that example were that the property was purchased and sold at $160k (no appreciation) and held for 10 years. The correct annual return represented by this stream of cashflows and outlays is 14.41%. 
MIP 176k 2Pct Appreciation
Purchase Price of $176k with 2% Annual Appreciation
Now let’s take a look at the example where we paid 10% more for the same property. Wait a second, what’s going on here? Isn’t the return supposed to be lower because the higher price lowered our cashflow and increased our investment? No, not quite. In this example, we changed the price but also revised the assumption to account for 2% annual appreciation (the rate of inflation). The result: The overall return on investment was actually higher despite the higher price tag. 

No loss – just transfer

The shift from stagnant Buyer markets to appreciating Seller markets puts downward pressure on cashflow returns as more of the property’s income goes to service debt and required investment rises. However, the very reason that caused your cashflow returns to shrink, causes your investment to yield an even higher return in the end. The principal reason for this phenomenon is leverage. When you purchase a property using a 20% down payment, you are investing one dollar for every 4 dollars you borrow from the bank. But when the property goes up in value you reap 100% of the appreciation benefits. So in the scenario above where we’re conservatively assuming that the property is rising in value at the rate of inflation (2%) your “cash on cash return” from the value appreciation is actually 10% – or 5 times the property appreciation rate due to leverage. Therefore, in trying to figure out next steps in this environment, the poignant question you must ask yourself is this: When do I need the money; now or later? If you’re looking for a property that will produce income that you can use to subsidize your current income and consume right away, this environment of rising prices is really hurting your returns. There’s no other way to put it. But if you’re a long term investor that doesn’t need the cashflow right now but will utilize it to grow your capital base and increase income at retirement, don’t fear the change in the market. Rather take a look at the whole investment picture and see if the transfer in returns (from cashflow to appreciation) might work out better for you in the end.

Caveat Emptor

There are some important caveats to my arguments above. First, when I talk about appreciation, I am referring to organic appreciation that is based on real economic underpinnings and growth. I am not referring to speculative 20%+ appreciation in highly volatile markets. Building a real estate investment portfolio based on that assumption is akin to building your home on a foundation of sand. Second, I am not suggesting that the transfer of returns from cashflow to appreciation makes every scenario plausible. For instance, regardless of the appreciation rate, it is never okay to purchase a property with negative cashflow. Let me repeat that. Under no circumstances. When your plan consists of taking sure losses while chasing after potential profits, it usually doesn’t end well.

What are your thoughts?

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About Author

Erion Shehaj (G+) is Investing Architect. He helps people craft a Blueprint investing strategy that leads to accelerated capital growth, higher income and lower taxes. Side effects might include: Early retirement, wealth and piece of mind. Follow on Twitter if that's your thing.

16 Comments

    • Erion Shehaj

      That’s a very short term perspective applied to a long term investment, Dennis. People often make a similar argument with regard to investing in the stock market. In other words, sell when the market is hot and buy when it bottoms again. In short, time the market. This inevitably opens the door to “mistiming” the market and achieving the exact opposite of what you set out to do. In part, this is the reason why the average American retires with about 75k in their retirement account.

  1. Excellent examples, Erion! In the forums, you almost never see investors discussing their IRR’s when they are performing a deal analysis, but this article serves as a wake up call that we should.

    • Erion Shehaj

      Hey Sharon – Thanks for the kind comment. The quality of decisions you make when investing in real estate long term is inseparably tied to the quality of the information you use in making that decision. I’d say, the ability to properly calculate the return on investment on the property determines the quality of the information and therefore the quality of decisions you make.

  2. Erion,
    Well made points. Thank you.

    I am in a steady, low inflation market so I have traditionally been skeptical of inflation assumptions in my own IRR calculations. I like the reliability and consistency of using net income and amortization as my drivers of yield.

    While I can see the benefit of using leverage with inflation, isn’t their some risk factor we have to build in because of inherent uncertainty of amount, timing, and length of inflation? I just don’t get the confidence of relying on even a 2% inflation rate to make my deal good vs another that starts with a good net income from day 1.

    How do you handle this for yourself?

    • Erion Shehaj

      @Chad

      Excellent, excellent question!

      I think you are using the term “inflation” and “appreciation” interchangeably and they’re slightly different phenomena. Inflation is pretty reliable over the long term. Sure, there are periods of stagnation etc but over the long term you can pretty much count on 2-3% annual inflation. Appreciation is growth in property value that comes from different factors, inflation being one of them. Other factors include supply and demand imbalance, trendiness of an area, population growth, or just sheer madness of the buying population :-)

      You’re right that “betting the whole house” on the belief that values will rise with time carries a lot of risk. Especially if there are no other returns to speak of. But when you assume that the appreciation rate will be the rate of inflation, you are mitigating that risk considerably. As an example property values in my market went up 12% last year. If I assumed 10% annual growth in prices in my numbers, I’m just patting myself on the back and making myself feel better about this investment. But if I assume 2% appreciation and it ends up being 5-7% a year, I don’t thing I would be mad at myself later.

  3. The real key to the whole thing is your point about never buying something that is cashflow negative. As long as you are positive on that you can weather the storm.

    Using the basic plan you have here if someone was doing this in 1998-2001 it might not make a lot of sense to start selling the places in 10 years. However as long as they had the healthy cashflow then they can turn the 10 year plan into the 15 year plan and they reap the appreciation component too.

    • Erion Shehaj

      Hi Shaun

      That’s exactly right. And the 10 year sale assumption is just that, an assumption. Typically, the investor would assess how the market is doing and make a decision on whether it is smart to sell or hold on.

  4. Abel Vazquez on

    This an interesting article. I always thought that betting on appreciation was a bad thing and that the appreciation should be the cherry on the Sunday but looking at it from the perspective you just mentioned it seems to also make sense that for a more seasoned investor both options can be profitable in the long run. Any ways great article Region and thank you.

    Abel

    • Erion Shehaj

      It’s all about what the market gives you Abel. If you can get 15% cashflow returns and some appreciation as the cherry on top, that’s obviously better. But the fact is the market doesn’t always give you spring – sometimes it’s autumn and sometimes is winter. Therefore if you’re trying to develop a consistent investment plan you can’t just invest like a vulture – picking up the pieces when things go very wrong. You can make money that way don’t get me wrong but you can’t build retirement income that way.

    • Erion Shehaj

      @ Kevin

      It’s an imperfect measure for sure. It assumes and relies on reinvestment of cashflows at a similar return. But in comparison to a Year 1 cash on cash return it’s lightyears ahead.

      • Sorry Erion. I don’t see that IRR is in any way a superior tool for making these sort of comparisons.

        As the Wikipedia article points out, when cash flow change direction, the IRR calculation can lead to poor results.

        • Erion Shehaj

          I think you just made my point for me, Kevin.

          If you’re using the first year’s cash on cash return to evaluate a multi year long term investment, you aren’t even taking into consideration the fact that are other year’s cashflows in this picture. So, if your first year cash on cash was 15% but then as you put it “cashflows” go in a different direction and you lose 15% on your money, how accurate was your cash on cash return? That was my point all along – that IRR with all its flaws gives you a better overhead picture of what happens in an investment during its life than a short term one year measure.

          But I guess we’ll agree to disagree on this and stay friends. :-)

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