Posted about 1 year ago

The One Big Flaw in Buy-and-Hold Investing

I am a buy and hold investor. Cut my signing hand with a carpenters knife and I bleed "buy and hold" all day long. Transactions costs and taxes are so destructive to capital that I've always steered clear of the real estate "fast trade". But, over time, the buy and hold model breaks down. Let me explain.

I got my start in real estate investing by turning my house into a rental property, i.e. house hacking. Over time I was able to get a few more rental properties and graduated into owning a portfolio of smaller properties. The single-family houses performed well, but I was most excited about my multifamily acquisitions. I had purchased a triplex from a seller on Craigslist and a short time later added a duplex to my portfolio. Right away I began to see the economies of scale work in my favor on the multi-family properties. Unlike my single-family houses, my multi-family properties were always producing income, even during times when I experienced tenant turnover. If one unit went vacant, the other two units kept chugging along, providing income that paid the mortgage, taxes and insurance. My plan was paying off.

Capital Drag: The Art and Science of Redeploying Capital

After a couple years of managing my portfolio as best I knew how, my equity in the properties had grown. I was beginning to see the payoff that every investor works so hard to see. My equity had grown substantially and I was getting excited. this point in my evolution as a real estate investor, I knew I needed to start thinking bigger. My equity had grown, but because of this my capital drag began to increase. Capital drag occurs when rate of equity growth slows down as the equity in the project or investment increases. Here is an example: Imagine I pay $100,000 for a house that rents for $1,000 per month. Say I put $25,000 down on the house to close. My equity at the beginning of year 1 is $25,000. Now, let’s imagine my cash flow for year 1 (annual rents – mortgage, taxes, insurance, cap-ex, maintenance, vacancies, etc.) is $2500. Now let’s also imagine that house prices increase by 5% in my area. My cash flow of $2500 plus my appreciation of 5% ($5,000) gives me a return on equity (ROE) of 30%, ($7,500/$25,000).

In year 2, I’m able to increase the rent rate by 5% to $1050. I also experience increased costs of labor and materials for cap-ex and maintenance, so my cash flow improvement is incremental. In year 2, my cash flow is $2700, and at 5% my appreciation is $5250, ($105,000 *.05) putting my ROE at 26.5%, ($7950/$30,000). $30,000 is the equity position at the start of year two. As the equity increases, the ROE begins to slow. Now, these are really good numbers, so I want to hold this property longer, but as you can see, over time, the ROE will begin to sag the more the equity in the property grows. This is what I call Capital Drag.

I imagine Capital Drag like a boat that is sleek and fast in its early age. Over time, however, as cargo is added and the mast and rigging gets thrashed it isn’t as efficient. It cannot make the most use of the winds as they blow. The boat slows down. But like a good captain, I need to be willing to throw the cargo overboard if it means getting out the drag in order to get to my destination faster. As an investor, I’m a capital manager. Buying an asset and holding it forever is comfortable. It’s convenient, but a prudent investor is always thinking about how to keep his capital growing as fast as it can grow with the least risk possible.

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Now, it should be stated that I could loosen up my capital drag by putting additional debt on my smaller properties to buy more. Yes, this is an option, but there are lots of obstacles to this approach. Loan amounts may not be large enough to buy more properties, my debt-to-income ratio might inhibit me due to standards related to residential loan rules, and my job as a landlord increases. I’m not interested in that approach. Eventually, like most investors I want to get to passive income that will allow me to pursue other things in my life. I need to go bigger. 

This is what has led me into the pursuit of large multi-family deals. If find they are an efficient tool to redeploy capital on an ongoing basis. They can even provide a better and easier way to minimize capital gains taxes if sponsors continue to have other deals I can roll my capital into. Capital drag isn’t the end of the world for the investor, but it does require us to pay attention and constantly be on the lookout for other opportunities that keep us on the path of growth.