There are many savvy real estate investors out there that understand how commercial and residential income properties operate. They can spot value-add opportunities a mile away, and they have the team necessary to implement them. They are confident that at any given time, they can find a real estate investment worthy of pursuit. They faithfully perform due diligence, and they formulate investment analyses and plans that are more spot on than Nostradamus’s predictions ever were.
The above-described investors will undoubtedly make money in real estate. The question remains: are they building their wealth as quickly as they can? After all, wouldn’t you rather make a million dollars in ten years instead of in twenty?
One of the best ways to optimize your money’s growth in real estate investing is to optimize your properties’ holding periods.
Let me explain.
What is the Optimum Holding Period for Real Estate?
I’ve encountered investors inquiring about the ideal holding period for their value-add investment. A typical inquiry goes something like this: “This investment I’m looking at has a two-year holding period and an average internal rate of return (IRR) of 30% over that time frame. If I hold it for one more year, however, I noticed that the average IRR drops to 25%. That is still a fantastic return. Should I hold the investment for an extra year, or should I get out after the two year holding period?”
To understand my answer is to understand the IRR metric and the time value of money. Let’s look at an example illustrating why it would be most advisable to hold onto the investment for only two years instead of three.
Two investors, Larry and Sean, would both like to invest $100,000 each over a six-year period with a primary goal of increasing their net worth. They are each considering investments with a 30% IRR over two years ad 25% over 3 years. Larry intuitively believes that the longer term 3-year year holding period is best and opts to invest in the 25% IRR twice over the six-year period. Sean, on the other hand, opts to invest in the 30% IRR investment three times in a row over the six-year period. Let’s compare their results:
Initial Investment – $100,000
Investment Proceeds- $381,470
Net Gain – $281,470
Initial Investment – $100,000
Investment Proceeds- $482,681
Net Gain- $382,681
As you can deduce from above numbers, Sean Shortter gained $101,211 more than Larry Longterm. Sean’s net gain was 36% higher than Larry’s! How can that be? While some might expect that Sean would earn 20% more than Larry (since 30% IRR is 20 percent higher than 25% IRR), he did not. Larry Longterm overlooked the opportunity cost of reinvesting his money at a higher return and the value of compounding. Remember, the optimal holding period for an investment is the period that yields the highest average IRR.
Of course, all investors have different objectives and, thus, all employ different strategies. If your goal is to drastically increase your net worth, consider utilizing the above advice. Happy investing!
Photo Credit: ollesvensson