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