Alameda, CA · Member since 2020 · 36 posts · 6 votes
I don't quite understand this so called "law of diminishing returns". It shows up in the BP calculator each time I analyze a property. The ROI percentage starts to go down at about the 10 year mark. Plus I keep hearing that investors tend to sell after 5 to 7 years because of this.
I would think that the pay down on principal and increase in appreciation would create a compounding return.
Rental Property Investor · Raleigh, NC · Member since 2016 · 393 posts · 995 votes
5y
Returns go down because the degree at which you are utilizing leverage is also going down.
If you buy a property for 100k with a 75k loan then you only have 25k of equity in the deal so your LTV is 75%. If you get 3% appreciation then your property is now worth 103k and you "made" 3k returns on your 25k in equity which is a 12% return via appreciation alone.
Fast forward a few years when your home is now worth 150k and your loan is paid down to 70k. In this instance you now have 80k worth of equity making your LTV ratio is much lower at only 46%. So the same 3% appreciation means your home is now worth 154.5k so you made 4.5k in appreciation. 4.5k returns on 80k worth of equity is only a 5.6% rate of return via appreciation.
If you own the property long enough to completely pay off the loan, then a 3% appreciation rate means that you are only earning 3% profit off of your money via appreciation.
The longer you own a property the more equity you have via appreciation and loan paydown. This equity means you are using less leverage and therefore your rate of return becomes lower. Higher amounts of leverage amplifies your gains, but also amplifies any potential losses making it generally riskier if the economy suddenly turns for the worse. So the tradeoff becomes creating a sufficiently high rate of return, while also not exposing yourself to an unnecessary amount of risk. Peoples have different degrees of risk tolerance so there is no best way to go about doing things, just find a sweet spot as far as risk/reward that works well for you and your investing goals.
Some people choose to sell their properties after awhile to buy new properties (hopefully at below market value) and thus earn instant equity by buying correctly, and it also resets their leverage back to a higher amount thus amplifying their gains. The downside is that repeatedly paying closing costs can become expensive. Alternatively some people choose to take out second mortgages via a HELOC against their property or simply refinance the entire thing and pull money out of it that way so that they can increase their leverage.
Specialist · New York City, NY · Member since 2019 · 399 posts · 168 votes
5y
To be more precise, ROI, calculated as (gain from investment - cost of investment) / (cost of investment) does not go down with time, unless you generate losses over the years. What goes down is your Internal Rate of Return (IRR), or any measure that takes into account time value of money (which means cash you get now is worth more than cash you get in the future). That's why, most of the time, you can optimize your project's IRR by selling earlier than what you would expect because you can properly time your big pay-off date (i.e. your property sale date).
Rental Property Investor · Minneapolis, MN · Member since 2020 · 540 posts · 285 votes
5y
@Brian Paine
It’s not taking into account the increases in market rent, or property appreciation. Some sell after 5-7, some so sell and/or 1031 - some refinance (a 2nd time) to pull out equity.
Rental Property Investor · Raleigh, NC · Member since 2016 · 393 posts · 995 votes
5y
Returns go down because the degree at which you are utilizing leverage is also going down.
If you buy a property for 100k with a 75k loan then you only have 25k of equity in the deal so your LTV is 75%. If you get 3% appreciation then your property is now worth 103k and you "made" 3k returns on your 25k in equity which is a 12% return via appreciation alone.
Fast forward a few years when your home is now worth 150k and your loan is paid down to 70k. In this instance you now have 80k worth of equity making your LTV ratio is much lower at only 46%. So the same 3% appreciation means your home is now worth 154.5k so you made 4.5k in appreciation. 4.5k returns on 80k worth of equity is only a 5.6% rate of return via appreciation.
If you own the property long enough to completely pay off the loan, then a 3% appreciation rate means that you are only earning 3% profit off of your money via appreciation.
The longer you own a property the more equity you have via appreciation and loan paydown. This equity means you are using less leverage and therefore your rate of return becomes lower. Higher amounts of leverage amplifies your gains, but also amplifies any potential losses making it generally riskier if the economy suddenly turns for the worse. So the tradeoff becomes creating a sufficiently high rate of return, while also not exposing yourself to an unnecessary amount of risk. Peoples have different degrees of risk tolerance so there is no best way to go about doing things, just find a sweet spot as far as risk/reward that works well for you and your investing goals.
Some people choose to sell their properties after awhile to buy new properties (hopefully at below market value) and thus earn instant equity by buying correctly, and it also resets their leverage back to a higher amount thus amplifying their gains. The downside is that repeatedly paying closing costs can become expensive. Alternatively some people choose to take out second mortgages via a HELOC against their property or simply refinance the entire thing and pull money out of it that way so that they can increase their leverage.
It really is just an "accounting thing," if you will. Since the ROI is based on the amount of money you've put into the deal, its keep changing because you are constantly paying down the mortgage by making principal payments. I'd be happy to talk it through with you. Just send me a direct message.
Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes
5y
"The ROI percentage starts to go down at about the 10 year mark."
Do you mean ROE? It's kinda related, but consider:
1) Your debt is decreasing
2) Your prop value (we hope) is going up
3) Means your equity is going up. Equity starts with your down payment amount on purchase.
4) Your CFBT off the property is going up, but not as fast as equity (value-debt owed) is growing
5) ROE = CFBT/Equity, so it shrinks if Equity grows faster than CFBT.
You can always re-fi (ie raise the debt) and decrease the equity. I'd assume you'd use the cash-out beyond existing debt payoff to invest somewhere else.