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.
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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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