Real Estate Investing in the Real World
Real Estate Blog
FRIDAY, DECEMBER 07, 2007

In A Brief History of Time, Stephen Hawking mentions a publisher’s rule of thumb that every equation that a writer uses will cut his readership in half. Real estate investing is based on relatively simple principles - especially compared to the stuff that Hawking tackles - but there are some real estate investing concepts that can be delivered a bit more effectively aided by a few equations and numerical examples. So bear with me...

I wrote in a recent column that when an investment starts “getting good” – when it starts kicking off some cashflow and putting some dollars in your pocket on a month-to-month basis – then that’s the time to sell. This might sound counter-intuitive, but I’ll give a couple of examples that show why it is true.

Judged on the basis of simple price appreciation, the stock market beats the pants off of the real estate market. Over the past twenty years the S&P 500 has appreciated at an average rate of almost 10 percent per annum, and the NASDAQ has averaged over 11 percent. Over the same period the average home price in America has increased at around 5.6 percent. So why do we get excited about the real estate market? Because it allows the investor to prudently use leverage to increase her returns. So why should we consider selling when the investment starts kicking off cashflow? It’s because this is a good sign that your leverage is running out of steam.

Let’s look at a simple example. An investor puts 20% down on a $100,000 property. The investor starts out with $20,000 equity on a $100,000 house, giving him 5-to-1 leverage. Meaning: if the market goes up by 5% then the value of the house goes up by $5,000, a 25% return on the initial $20,000 investment. This is a basic concept you’re probably familiar with.

As time passes by two things are likely to happen: a) the property will appreciate in value (good) and b) your loan balance will go down (also good). But there’s an unintended by-product of these two factors: a decrease in your leverage.

The graph above assumes a fixed rate mortgage at 8% and a property appreciation rate of 4.5% per annum. Now this isn’t a bad investment – in fifteen years that initial $20,000 grows to over $120,000 in equity. That’s an annualized rate of return of around 14%, better than you'd expect out of the stock market. But look what happens to leverage. By year five you can expect to have paid off around $4,000 of the loan. And assuming a 4.5% rate of appreciation, the property will have gone up in value by around $24,000. That adds a total of $28,000 to your equity – so now you have $48,000 tied up in the property. So here’s the results:

  • Initial leverage: $100,000 property ÷ $20,000 equity = 5 to 1 leverage
  • Five years later: $124,000 property ÷ $48,000 equity = 2.6 to 1 leverage

I don’t day trade stocks and I don’t flip houses – but that doesn’t mean I’m a completely passive investor, either. Smart investors know when it’s time to rebalance – and when your leverage starts falling it’s time to think about re-balancing.

The chart above shows an investor who rolls up his sleeves every five years, sells his properties and reinvests the equity. In the example above, the investor’s $100,000 property had grown to $124,000 – that’s good. But the $48,000 in equity now translates into a 20% down payment on a $240,000 duplex.

Summary:  Sell the property for $124,000, extracting $48,000 in equity.  Use the $48k to put 20% down on a $240,000 property via a 1031 tax deferred exchange.  Five years later: repeat.

Adopting this philosophy can have a dramatic impact on the long term performance of your real estate portfolio. Let’s look at the equity from the two figures above. In the first case, as mentioned above, the initial $20,000 investment grows into just over $120,000 of equity over the fifteen year period. Not too shabby. But the re-leveraged case is far more lucrative, growing to over $250,000 in the same period.

I’m a buy-and-hold investor, but that doesn’t mean holding forever. By executing a 1031 exchange every five years a real estate investor is able to maintain the desired level of leverage and risk and ensures that his real estate portfolio maintains momentum over time.

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Comments(11)
posted by: Chris Smith
Comments
December 09, 2007
01:05 PM
Does your online software include the graphs above? If so, I'm in.
December 09, 2007
10:08 PM
Fred :: Not just yet. But watch this space; in 2008 we'll be offering some new free features on the site. If this type of analysis appeals to you then you might want to stay tuned...
December 10, 2007
02:10 AM
Sir I really appreciate the effort made by you in doing the number crunching and making this entire thing simplified for us to understand it properly. Well what i feel is that there is no clear cut formula by which we can judge as in where we should put in our money...Real Estate or Equity It's all on the basis of the present situation of the market ,their performance in the past.
December 10, 2007
06:00 PM
Bravo! Bravo! This is another take on my "Measuring Equity" that I'm always talking about. Quite simply, what is the current return on your actual equity in the house. Could it be better leveraged elsewhere?

It's really that simple to know when/where to rebalance. Loved your take on it.
December 11, 2007
12:39 AM
Chris:
I loved your recent series of articles on investing in real estate and the comparisions to investing in the stock market. I appreciate your analytical take on these issues.
I totally get the idea of using leverage to maximize the return on invested dollars in real estate.
I do have a question. In your chart comparing the base case ($120K in equity) versus the re-leveraged case ($250K in equity) after 15 years, do you assume the monthly cash flow in each scenario is the same? Comparing the 2 scenarios, one gains $130,000 more in equity over 15 years from re-balancing the real estate - this works out to about $8,600 per year (or about $710 per month) over the 15 years. In my experience, cash flow goes down when leverage goes up. Assuming cash flow has not been considered in the above analysis, it would be interesting to see what the returns in both cases look like when cash flow is included in the analysis.
December 11, 2007
10:11 AM
Arn:

I think yours is a great observation (thanks) and the answer, in my opinion, is complicated.

The issue that you mention is a knife that cuts both ways, so I simplified the analysis by assuming it away. But here’s my view on the issue, which I’ll expand upon in a future post...

If you put 5% down on a $100,000 house it will definately generate less cashflow than if you put 20% down. So yes – hold everything constant and cashflow goes down when leverage goes up. But that’s not exactly what’s happening in the case.

Consider the two end points. Unleveraged: the investor ends up with a property valued at $185,000 on which he’s paying around $600 per month (still paying off that 30 year 8% mortgage). Leveraged: the investor ends up with a property that’s worth around $700,000 on which she’s paying around $3,500 per month (making roughly the same assumptions).

So the bigger, higher leveraged property costs the investor around $2,900 more per month in principal plus interest. But...it’s not unreasonable to image that compared to a $185k single family house a $700k fourplex would generate income that covers this gap with room to spare for higher expenses and taxes, etc. You could imagine a case in which the leveraged guy ends up with *more* cashflow at the end of the day.

Or maybe not. All depends on the assumptions, and now we’re trying to look into our crystal ball. Which is why I kinda swept the whole issue under the carpet and sealed it with a keep-it-simple stamp. But it’s something that might help you or might hurt you, depending on how you re-invested the funds.

Another thing to consider. I'm in Houston and I see you're in Palo Alto CA. The numbers above are relevant for lots of markets (Dallas, Tulsa, Houston, Atlanta, Cincinnati, Cleveland, Memphis, Indianapolis, etc. etc.) but they don't work for others (CA Bay Area, Florida, Las Vegas, Manhattan, etc etc).

That’s my take, anyway.
December 11, 2007
10:12 AM
Understood - you are exactly right - the entire picture is complicated - I imagine some of the answer is dependent on the CAP rate of the properties involved and the interest rate on the financing. I am located in the San Francisco Peninsula where generally one needs about 40% down payment to break even. Your analysis does explain why most investors do wish to continually trade up into bigger more expensive properties - to keep leverage working for them. I think the other factor which works in trading up is kind of an economy of scale. Typically larger properties offer higher CAP rates and lower GRMs which works towards making the large properties better investments.
December 23, 2007
11:06 PM
Wow Chris, what an elegant explanation of leverage. This is a concept I learned about in an investing class, but your charts, and the simplicity of the example, really illustrate it so well. Nicely done!
January 15, 2008
10:08 PM
Nice web page! I especially enjoyed the graphs. I was bouncing around Google to try and find some solid quantitative data pointing to either stock market investing or real estate investing as the best path to wealth. I could not find any, which is shocking! However, I did stumble across your page and enjoyed your idea of optimizing the leverage "multiplier". How would you contrast your technique of doing 1031 exchanges versus simply pulling out the equity after 5 years and buying another similar property? Then in the 10th year buying two more properties - and the 15th year finding yourself on the cusp of being able to buy four more for a total of eight. This assumes many things, particularly 15 years of appreciation (which you assume as well), and finding similar properties, etc. Then again, finding 1031 exchanges takes some legwork as well. What I like about my idea is that I stay focused on blue-collar, honest-Joe tenants in a certain pricepoint. By ramping up the "empire" through 1031 exchanges into bigger units, I am facing an eventual Peter Principle where I will outstrip my ability to manage the complexities of, for example, an apartment complex - which sounds like your next move at the 15 year mark. Also, there is something which you ignore in your analysis - that leverage, while the Genie of profit, can also spell doom. As I get older I believe that my tolerance for redlining leverage will get smaller. Lastly, I want to add that I really enjoyed your Bio page. You sound like an outstanding guy with, no doubt, a great family and a great future ahead of you. Kudos to you! --Max
January 16, 2008
04:24 PM
I just read the blog at this mortgage site that addresses some fo the refinancing buzz going on in the mortgage industry. Read the lates blog post for latest on mortgage industryk Houston mortgage for multiple mortgage brokers quotes on your next home loan.
January 16, 2008
11:43 PM
Max: Thanks for your comment, and glad to have you as a reader. As for 1031 exchanges - the real benefit is that you keep those tax dollars in your portfolio working for you throughout the life of your investing career, vs. paying them to the government every time you sell. So you can keep your leverage rolling without doing a 1031, it's just not as efficient.

Also, I'd argue that you can employ this strategy without eventually ending up over your head with a monster apartment complex. You can do a lot turning a house into two houses, then turning two houses into a fourplex, then turning a fourplex into two fourplexes. You'll need a property manager at some point, but that's a pretty good problem to have in my book.
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