The Rate of Return from ONLY Principal Paydown

General Real Estate Investing
5yFollow

The Rate of Return from ONLY Principal Paydown

Andrew SyriosPro Member
Moderator
Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes

I was curious on what the rate of return would be on real estate from nothing more than principal paydown alone. Turns out it's not that shabby. Using my trusty CCIM Institute financial calculator, if you get a 80% LTV loan with a 20 year amortization, then break even for 20 years while the property gains nothing in value (which never happens over 20 years), the rate of return is still 7.18%.

Yes, it's not a "cash return," it's just "equity and no, it's not incredible by any means, but nothing to sneeze at. The historical average for the stock market is about 10%. (https://www.nerdwallet.com/.../average-stock-market-return) And this is just principal paydown. It doesn't include the appreciation (like the insanity we're seeing now), tax advantages cash flow or the other advantages of buy and hold: https://www.biggerpockets.com/...

It would also be a lower return if you paid it off early as the early payments are mostly interest, but it still shows the power of buy and hold real estate.

Overall, another reason to love real estate.

Podcast Guest on Show #121
10Reply
188 views

Most Popular Reply

Joe VilleneuvePro Member
Plymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
5y

I went back and read the posts here again. Somehow I got confused (I think) and I apologize. Somewhere I interpreted the paydown we were talking about as coming "out of pocket" and not exclusively coming from the normal mortgage payment that's paid by the tenant's rent money. Of course mortgage paydown is a gain, if the money comes from the rent and not the cash flow or the REI's own personal cash.

As a result, I fired my proof reader (that would be my body double).

12Reply
See this reply in the discussion

68 Replies

Jump to latestLatest
  • Nick Barlow
    Warsaw, IN · Member since 2017 · 229 posts · 270 votes
    5y

    @Andrew Syrios those are some good graphs and I appreciate you doing the work and sharing with the community.

    Going forward, due to current inflated prices, a lot of institutions are recommending investors lower their expectations to a 3-5% range-well below the 10% cited.

    For me, it’s still RE way more than stocks everyday of the week-you just proved that a bad RE investment beats the indices WITHOUT any of the other benefits.

    0Reply
  • Scott TrenchPro Member
    Rental Property Investor · Denver, CO · Member since 2014 · 2k+ posts · 6k+ votes
    5y

    I agree with a lot of other thoughts on this thread, but I'll put a little spin on it. 

    Like @Andrew Syrios says, for me the cash flow is the cherry on top. I invest for long-term appreciation and amortization of the debt from rental cash flows. After 7 years in Denver, inflation and rental growth has actually created a ton of cash flow for me, but nothing compared to the equity value created. Buying and holding in a growth market seems to me to be the real trick.

    However, I do think there is a base level of passive cash flow that one needs to feel good about their life and to feel truly diversified away from wage income. I agree that the cash flow won't make you rich in and of itself, but having the cash flow might encourage the investor to take a few risks, start a business, leave the job, etc. If investing for cash flows creates this outcome even 1-2 years earlier than other approaches, it may create a life of options and outcomes that we can't predict.


    In other words, the return on investing strictly for cash flow might be infinite - the realization of one's potential.

    Podcast Guest on Show #223
    BiggerPockets
    2Reply
  • Tom DegroodtPro Member
    Evans, GA · Member since 2016 · 122 posts · 65 votes
    5y

    Cash flow certainly adds runway and reduces your monthly needs. Wealth is created kind of under the waterline. It’s amazing what time value adds. 

    0Reply
  • Andrew SyriosPro Member
    Moderator
    OP
    Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes
    5y
    Originally posted by @Jonathan G.:

    @Andrew Syrios

    Funny! Everyone here is making "money " or "equity ". Different strokes but eventually , everyone is getting paid. Gotta love REI.

     Real estate is so great we all argue about which one of its advantages makes us the most money!

    Podcast Guest on Show #121
    1Reply
  • Andrew SyriosPro Member
    Moderator
    OP
    Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes
    5y
    Originally posted by @Nick Barlow:

    @Andrew Syrios those are some good graphs and I appreciate you doing the work and sharing with the community.

    Going forward, due to current inflated prices, a lot of institutions are recommending investors lower their expectations to a 3-5% range-well below the 10% cited.

    For me, it’s still RE way more than stocks everyday of the week-you just proved that a bad RE investment beats the indices WITHOUT any of the other benefits.

    True, I would expect the stock market to eventually cool off here along with the real estate market. But over the long run, it will probably return to the ~10% returns it's been in the past. 

    Podcast Guest on Show #121
    0Reply
  • Andrew SyriosPro Member
    Moderator
    OP
    Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes
    5y
    Originally posted by @Scott Trench:

    I agree with a lot of other thoughts on this thread, but I'll put a little spin on it. 

    Like @Andrew Syrios says, for me the cash flow is the cherry on top. I invest for long-term appreciation and amortization of the debt from rental cash flows. After 7 years in Denver, inflation and rental growth has actually created a ton of cash flow for me, but nothing compared to the equity value created. Buying and holding in a growth market seems to me to be the real trick.

    However, I do think there is a base level of passive cash flow that one needs to feel good about their life and to feel truly diversified away from wage income. I agree that the cash flow won't make you rich in and of itself, but having the cash flow might encourage the investor to take a few risks, start a business, leave the job, etc. If investing for cash flows creates this outcome even 1-2 years earlier than other approaches, it may create a life of options and outcomes that we can't predict.


    In other words, the return on investing strictly for cash flow might be infinite - the realization of one's potential.

    It's really important to get new investors to understand that cash flow is not how you become wealthy with real estate. It's the appreciation and principal paydown along with the ability to buy with equity upfront and the tax benefits too. The cash flow is nice, but not going to get you rich. It is essential to have cash-flowing properties IMO to make sure you stay solvent, get approved for loans, mitigate risk if the market falls and make sure you don't have to sell or refinance constantly to raise funds. And as you put it too, it's also important psychologically as well as it feels like you're losing money each month if you have negative cash flow even if all the other things are working in your favor. 

    Podcast Guest on Show #121
    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Andrew Syrios

    Good point.  I think many new investors look at the "older investors" who may have an income producing portfolio.  Unless they can talk honestly with them or the investor is pretty "honest," these new investors may not realize that the cash flow is really the person's retirement.  Only some of these old investors will caveat their current investment strategy.

    as with any investment strategy, it has to match the investor's goals... not somebody elses.

    0Reply
  • Arn CenedellaPro Member
    Rental Property Investor · Greenville, SC · Member since 2008 · 786 posts · 1k+ votes
    5y

    @Andrew Syrios

    There would have been a lot less confusion and a lot less discussion if your assumption had been clearly stated in your original post.

    Yes principal pay down does increase equity, net worth, and therefore the return on investment. No argument there. I could even argue principal pay down could be considered part of the cash on cash return.

    Your post would have been better understood and more easily received if you stated:

    If one buys rental property with $20,000 down and a $80,000 loan AND one assumes the rent covers all cost of the ownership THEN the return is xxxxx%.

    Without stating the assumptions used in your analysis, it leads to confusion.

    I believe it is best to clearly state assumptions used in an kind of return calculation.

    [email protected]650-575-6114
    0Reply
  • Andrew SyriosPro Member
    Moderator
    OP
    Residential Real Estate Investor · Kansas City, MO · Member since 2014 · 10k+ posts · 5k+ votes
    5y
    Originally posted by @Arn Cenedella:

    @Andrew Syrios

    There would have been a lot less confusion and a lot less discussion if your assumption had been clearly stated in your original post.

    Yes principal pay down does increase equity, net worth, and therefore the return on investment. No argument there. I could even argue principal pay down could be considered part of the cash on cash return.

    Your post would have been better understood and more easily received if you stated:

    If one buys rental property with $20,000 down and a $80,000 loan AND one assumes the rent covers all cost of the ownership THEN the return is xxxxx%.

    Without stating the assumptions used in your analysis, it leads to confusion.

    I believe it is best to clearly state assumptions used in an kind of return calculation.

    I did state that assumption, although without much emphasis (bold added for this quote), "if you get a 80% LTV loan with a 20 year amortization, then break even for 20 years while the property gains nothing in value (which never happens over 20 years), the rate of return is still 7.18%." 

    I should have made it more explicit though as people tend to read quickly in forums. Being more explicit about the assumptions probably would have avoided some of the confusion. 

    Podcast Guest on Show #121
    0Reply
  • Allen L.
    Rental Property Investor · Chicago and mainly invests in KS remotely · Member since 2018 · 360 posts · 314 votes
    5y

    This is misleading because real estate appreciates. Taking into appreciation, the IRR from principal paydown is worse, because your equity base is higher. Yes in a poor market with no appreciation this looks right, but in an appreciating market the IRR from paydown is just worse. IRR cannot be looked at using a partial differential view.

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Allen L.

    I'm not an accounting/finance wiz, but why would appreciation make your return, whatever sort it is, worse?  To me, appreciation is just "free money/equity."  For example, if yo upurcahse something for $100 but sell for $150.  You only need to payback the loan equivalent on the $100.  The other $50 is "free."

    0Reply
  • Allen L.
    Rental Property Investor · Chicago and mainly invests in KS remotely · Member since 2018 · 360 posts · 314 votes
    5y
    Originally posted by @David M.:

    @Allen L.

    I'm not an accounting/finance wiz, but why would appreciation make your return, whatever sort it is, worse?  To me, appreciation is just "free money/equity."  For example, if yo upurcahse something for $100 but sell for $150.  You only need to payback the loan equivalent on the $100.  The other $50 is "free."

    Give you an example:

    Assume appreciation is 0%

    100K house, 20% down on 30 year at 4% fixed, at start of Y1 your base is 20K, at end Y1 you made 1.4K in principal but at start of Y2, your base is 21.4K, end of Y2 made approx 1.45K, and start of Y3 your base is 22.85K, etc.

    If appreciation is 3%

    start of Y1 20K, end of Y1 you made 1.4K + 3K appreciation, so start of Y2 your base is 24.4K, end of Y2 you made 1.45K paydown and 3.1K appreciation, so start of Y3 your base is 28.95K. 

    Because of appreciation, your equity (base) grows faster. Since principal pay down is fixed in both scenarios, your IRR strictly from principal pay down is lower. Yes you do make more money with appreciation + pay down not less, but saying 7% IRR from pay down is incorrect.

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Allen L.

    Oh, I think I see. You count the appreciation as part of the "investment" to base your percentage. Is that just how IRR is done? Just another example of statistics can be made to show different things? I just look at the return or money made against the money I used...

    Thanks for laying it out.

    0Reply
  • Allen L.
    Rental Property Investor · Chicago and mainly invests in KS remotely · Member since 2018 · 360 posts · 314 votes
    5y

    @David M. Right, so the 7% is strictly evaluating return from the time of purchase, but it is not compound return, which is what people use to look at investment returns. If we deposit $100 from year 1900 in a savings account for 121 years, and if it pays out $50 during year 2021, it is not a 50% return :)

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Allen L.

    Sure, I understand compounding.  But, in your example, it looked like you counted the appreciation rate as part of the basis.  So, your appreciate rate isn't "in addition" to the the princpal pay down, but now its part of the basis calculation.

    0Reply
  • Allen L.
    Rental Property Investor · Chicago and mainly invests in KS remotely · Member since 2018 · 360 posts · 314 votes
    5y

    In IRR calculations, appreciation is included in the basis. If a 100K house suddenly appreciates to 200K, but everything else equal, then the subsequent years' return on that property looks worse, because you have so much equity in that property. This is why buy and hold investors refinance on market upturns, to tap into equity and reduce their basis so they can then use the cash to buy more properties and improve capital efficiency on existing properties (I THINK even if after refi existing properties cash flows negative, you have to combine in PNL from new acquisitions because it came from the source capital so the total return from tapping the equity looks good).

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Allen L.

    Okay.  Thanks for explaining.  I don't think I'll remember it, though :)  That sounds like accounting/finance rules.  With your hypothetical here (100k house appreciates to 200k), I personally wouldn't see it as a reduction in my subsequent years' return.  It just unrealized gain/profit!!  But, I get your latter example of the refi's and looking at both deals to justify the leverage.  That's just leverage (to me anyway).  Thank a bunch.

    0Reply
  • Tony Kim
    Rental Property Investor · Los Angeles · Member since 2018 · 844 posts · 1k+ votes
    5y
    Originally posted by @Allen L.:
    Originally posted by @David M.:

    @Allen L.

    I'm not an accounting/finance wiz, but why would appreciation make your return, whatever sort it is, worse?  To me, appreciation is just "free money/equity."  For example, if yo upurcahse something for $100 but sell for $150.  You only need to payback the loan equivalent on the $100.  The other $50 is "free."

    Give you an example:

    Assume appreciation is 0%

    100K house, 20% down on 30 year at 4% fixed, at start of Y1 your base is 20K, at end Y1 you made 1.4K in principal but at start of Y2, your base is 21.4K, end of Y2 made approx 1.45K, and start of Y3 your base is 22.85K, etc.

    If appreciation is 3%

    start of Y1 20K, end of Y1 you made 1.4K + 3K appreciation, so start of Y2 your base is 24.4K, end of Y2 you made 1.45K paydown and 3.1K appreciation, so start of Y3 your base is 28.95K. 

    Because of appreciation, your equity (base) grows faster. Since principal pay down is fixed in both scenarios, your IRR strictly from principal pay down is lower. Yes you do make more money with appreciation + pay down not less, but saying 7% IRR from pay down is incorrect.

    Well, to be fair, the OP did state that just for the purposes of this illustration, we are assuming no appreciation in MV.

    Also, I think you are confusing ROE with IRR. I agree that with appreciation, you do have dilution of ROE because this is a performance metric that you can calculate between multiple different periods and geometrically link the periods together based on updated capital base values. However, how would one do that for an IRR calculation? It's just not possible. IRR is just a function of cash flow and in this illustration, we are just imagining the equity paydown in the form of cash-flows. The only way you would be able to make that same calculation is if we were to imagine selling the property at the end of a period at its appreciate price point and then repurchase at exactly the same price point. That would be the only way to make your illustration work when using IRR as a performance metric. But then, you'd essentially be warping this calculation into something for which it wasn't intended.

    If your position is that your return on equity is not that high due to appreciation, then I am 100% in agreement with you. But IRR is also another commonly used performance metric and the dilutive effect on mid-term payments received due to appreciation on the property is negligible.

    This is precisely why it's important to look at more than one performance metric, especially when evaluating investments such as syndications as it will give you an idea of the timing and amount of cash flows vs. expected capital appreciation.

    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free