@Miguel B. I work with plenty of investors who are still seeing decent returns in Austin. Sure the profit margin on your average fix & flip is a bit tighter but real estate investing is about adapting to change. The market in Austin is no longer producimg 30% ROI on flips or 1% returns on rentals unfortunately. It's a truth that many investors refuse to accept. But the savviest of investors will continue to find ways to minimize their costs (rehab, holding, realtor fees, etc.) in order to maximize their profits.
The buy and hold strategy in Austin is a good one as long as you can afford to do so long term. There are plenty of areas where properties will appreciate in value. Obviously conduct as much research and due-diligence prior to contracting and make sure the property cash flows at the very least.
Miguel, based on your question about SFRs / profitability, consider a few factors:
Just some food for thought.
@Miguel B. I work with plenty of investors who are still seeing decent returns in Austin. Sure the profit margin on your average fix & flip is a bit tighter but real estate investing is about adapting to change. The market in Austin is no longer producimg 30% ROI on flips or 1% returns on rentals unfortunately. It's a truth that many investors refuse to accept. But the savviest of investors will continue to find ways to minimize their costs (rehab, holding, realtor fees, etc.) in order to maximize their profits.
The buy and hold strategy in Austin is a good one as long as you can afford to do so long term. There are plenty of areas where properties will appreciate in value. Obviously conduct as much research and due-diligence prior to contracting and make sure the property cash flows at the very least.
To answer this question, you really just need to find some data and do some calculations. I've crunched some numbers in some neighborhoods in the Austin MSA and if I make a large enough downpayment, then rentals still work. However, it's more than I want to invest. A possible rental in a new subdivision might cost $240k and rent for $1500. Maybe I'd have to put $120k into the deal in order for there to be a comfortable cash flow to cover vacancies, repairs, etc.
Let's say you put 50% down. If the expected appreciation rate is 4%,then the total return might look something like this:
4% cash on cash.
2% principal paydown
8% on appreciation (2-to-1 leverage)
Total: 14%
Not bad, but it's just hypothetical. There is a nice calculator on HomeUnion where you can play with the numbers on some of their inventory.
Maybe you can do better with off-market deals and distressed properties.
My 2¢...
A loan for 120K at 5% means $644 monthly in PI. A 240K investment property will have about 5K+ in property taxes = $416/month. Your insurance, property management, vacancy, utilities (when vacant), repairs&incidentals, capital expenses will eat at least another 250/month. You are lucky if you manage to get $200/month clean cash flow.
That means $2400/year, or a grandiose Cash on Cash return of....2%. You can get that with some savings account and leaving the money in the bank, no risk, no effort.
You might get to 2% principal paydown in your 7th year...
@Nate R. Can you please elaborate on that "8% on appreciation (2-to-1 leverage)" - I'm not familiar with how you calculate this number. And how is relevant in the context of inflation (or when appreciation is just a reflection of inflation)?
@Costin I.: I mean you could expect about 4% appreciation on the price of the house based on historical rates. I think that's a pretty conservative estimate. To use my hypothetical example:
$240k * 0.04 = $9600
If you put $120k into the deal, that's an 8% return from appreciation. The return is double the appreciation rate due to using 50% leverage. If you paid cash in full, then the return is 4%.
Yes, you're right, the COC return is pretty low, which is typical in high-cost areas like Austin. My hypothetical example didn't take into account vacancies or maintenance reserves.
"And how is relevant in the context of inflation (or when appreciation is just a reflection of inflation)?"
Hmmm....
Inflation is currently running about 2%.
Houses go up in value on average over time. Inflation is higher prices on average due to an expansion in the money supply. In some markets, housing prices increase faster than inflation due to population dynamics and demand/supply imbalances. I only considered the nominal price increases you might expect as an investor. How much of this is due to inflation and how much is due to market forces is difficult to answer. In general, inflation is our friend. Another neat thing is that due to inflation, the value of our mortgages are eroded over time, so by using leverage we do even better.
Thanks @Nate R. for explaining.
As a primary buy&hold investor, with passive income as the goal, I come from a different perspective:
- The property appreciation is not something you can rely on, as nobody can predict the market fluctuations and time the market. Sure, you can look back and see how things went historically...but "past performance not a guarantee for future results". What if you plan to sell in 5 years from now and 5 years from now there is a recession or a major dip in RE prices? I don't think it is wise to base your buy&hold strategy on appreciation hopes, especially for houses with zero or negative cash flow. Appreciation is creme on top of the cake - it might be there, but it might not.
- Appreciation is a paper profit realized only when/if you sell. It's hope. If you plan on selling, you have to factor in the selling commisions (usually 6%), closing costs (probably 2%), depreciation recapture, taxes on the profit for a true return figure. I contend that if you are planning to hold for under 5 years, you are in fact a long term flipper, not a buy&hold investor.
- Leveraged appreciation (the way Nate considers it) is not just paper profit, is like virtual paper profit. A promise on a hope. It's not going to put any money in your pocket till you sell, and that only if you do it at the right time and in the right conditions. (And what happens if there is deflation? Unlikely, but still possible.)
- Then there is the inflation. To speak about appreciation, you need to speak about and understand inflation. I would say any investment needs to bring you more than the rate of inflation for a real gain. Heck, more than inflation and an additional 25%+ for taxes (e.g. if inflation is 2%, you need to make 2.5% return just to break even).
- And, again if you think long term and passive income, not just storage of wealth, if you can't redeploy that money into something better, how good is that appreciation? For example, let's say you buy a house that doubles in value in 10 years...but then all the similar houses in the area would also doubled in value. Can you sell the house and buy another similar one without adding more money? I doubt you can, not in the same area and condition.
How much of that appreciation is real, caused by area changes in economic conditions, or scarcity of land/space, etc. and how much is just a reflection of inflation (or quantitative easing, aka money printing)?
Read here for much better explanations that I can provide:
The-truth-about-the-real-estate-market
Inflation-adjusted-housing-prices/
So, yes, you can recover your investment when selling, and hope the appreciation gave you back more than inflation and taxes, or at least kept you in place and preserved the true value.
You can probably count on the net cash flow. And you can count on the equity increase (due to principal paydown by tenants, and even that should take in consideration vacancy, otherwise you do double dipping). The rest is wishful thinking.
But then again, this is just my opinion and from my limited perspective. It could be flawed and subject to feedback and corrections, which I very much welcome.
Thanks @Nate R. for explaining.
As a primary buy&hold investor, with passive income as the goal, I come from a different perspective:
...
Hi, Costin. There have been many debates here on BP on the merits of investing for appreciation vs. cash flow. These discussion have become quite heated, with some very vocal members insisting that the *only* reason to invest is for cash flow, with a similar minority claiming that the only reason to invest in real estate is appreciation.
I think the truth lies somewhere in the middle.
Regarding your points:
- The property appreciation is not something you can rely on, as nobody can predict the market fluctuations and time the market. Sure, you can look back and see how things went historically...but "past performance not a guarantee for future results". What if you plan to sell in 5 years from now and 5 years from now there is a recession or a major dip in RE prices? I don't think it is wise to base your buy&hold strategy on appreciation hopes, especially for houses with zero or negative cash flow. Appreciation is creme on top of the cake - it might be there, but it might not.
One of the points made in these earlier discussions was that being able to project prices and future cash flows is one of the skills that investors need. In single family, buying in the right markets and neighborhoods is critical, since future values depend on market forces. In commercial / multi-family, you can force appreciation by adding value and raising rents (assuming the market can absorb rent increases). Understanding the local market is important for any RE investing.
Yes, I agree RE investments should cash flow. The income should be enough to cover all operating expenses including vacancies and maintenance, with a cushion left over to provide a margin of safety at least.
Assuming the goal is to live off of passive income, those of us without enough capital to live off cash flow need capital growth. Once we get enough capital, then we can shift to living off of income. If we invest strictly for cash flow in the beginning, it will take a long time to build up enough capital such that the cash flow is sufficient to replace our active income.
My own thinking was like yours at one time, but has evolved somewhat with the benefit of hindsight as well as some introspection about what kind of investor I am. Properties with high cap rates and high rates of cash-on-cash returns tend to come with management headaches and extra risk. If I do any more SFH's, I'm willing to sacrifice some cash flow for quality and predictability of income. I am also invested in a couple of large Class C apartment complexes through partnerships, but I don't have to manage them and because of tenant diversification, the risk to our cash flow from a single bad tenant is insignificant. Anyways, the COC return on these is only 6-7%. The expected return is in the teens (IRR) and much of it comes from forced appreciation from value-add. But I digress...
As for your "what if" scenario, I agree you need to take market timing into account when you go into a deal. Maybe 5 years should be more like 7 years. If you buy in the right markets, there is little downside, though:
Yes, Texas Housing Prices Are Above their Pre-Recession Peak
https://www.connect.media/yes-texas-housing-prices...
Excerpt: ...during the Great Recession, housing prices fell 33%. Yet, Texas housing prices fell only by 13%, in comparison.
Appreciation is a paper profit realized only when/if you sell. It's hope. If you plan on selling, you have to factor in the selling commisions (usually 6%), closing costs (probably 2%), depreciation recapture, taxes on the profit for a true return figure. I contend that if you are planning to hold for under 5 years, you are in fact a long term flipper, not a buy&hold investor.
It would be a mistake not to factor those costs in when planning your acquisition and exit strategy. And are we just arguing about timeframes? If you hold "forever," you realize you will end up spending more on capex than the original cost of the building, right? At some point, the cost of replacing all the major systems in the house will start to eat into your cash-on-cash returns.
- And, again if you think long term and passive income, not just storage of wealth, if you can't redeploy that money into something better, how good is that appreciation? For example, let's say you buy a house that doubles in value in 10 years...but then all the similar houses in the area would also doubled in value. Can you sell the house and buy another similar one without adding more money? I doubt you can, not in the same area and condition.
The name of the game when you're trying to grow a RE portfolio is equity harvesting. You refinance or sell and use leverage to acquire additional properties, assuming that in the future, interest rates are still low enough vs. cap rates to perform the same kind of arbitrage as when you purchased the original property. Appreciation allows you to grow your portfolio faster. Again, this assumes your goal is capital growth. If you have enough capital to live off the income, then you don't need to leverage up and can afford to just sit back and collect cash flow.
At the end of the day it's about ROI and does it exceed inflation? That's the goal.
The problem is no one has a crystal ball, as you point out. That just makes it more challenging. :)
Whew that blew my hair back. @Miguel B. I would pay close attention to this thread, you have some very smart investors chiming in. Thank you @Nate R. and @Costin I. for the valuable input.
Got a couple questions for you Miguel... Are you looking for Cash Flow, appreciation, both? How do you plan on financing the deal? Are you considering Multi Family or SFR?