Repayment of capital | Think real estate
The forgotten advantage of real estate investing
With house prices skyrocketing as they are now, it’s understandable that most real estate investors are fixated on price appreciation, as the benefits of real estate investing far outweigh any other.
If another benefit competes with price appreciation in the minds of most investors, it’s cash flow. Indeed, many new investors (as well as many self-anointed “gurus”) like to talk about getting $ 2,000 or $ 3,000 or $ 5,000 or $ 10,000 per month in positive and passive cash flow.
“Sit down and cash the checks!” ” They say.
Both of those things are advantages of real estate, of course, but the price appreciation we are seeing right now is an aberration and the cash flow should only be seen as the icing on the cake.
Historically speaking, home appreciation has been just above inflation. It’s nice and when you add leverage it’s even nicer (four percent appreciation on a property with an 80 percent loan turns into a 20 percent gain). While there is no way to predict when the housing market will calm down, correct itself or even collapse, we can say with certainty that the annual price appreciation rates of 10-15% that we have observed will not last forever.
When it comes to cash flow, with homes in particular, most of it is reinvested in the property. You can make $ 200 / month, but then have a bad start and a turnover and lose all that profit. Capital improvements such as replacement of roofing, HVAC, siding, etc. typically consume a large portion of your cash and often all of it.
But don’t be discouraged.
I am convinced that real estate is the best way for a modest person to become wealthy independently. But it is with all the benefits of real estate that people gain wealth, not just appreciation and certainly not just cash. This includes tax benefits such as depreciation and the ability to use leverage while still being able to purchase undervalued properties, as real estate is an inefficient market.
But one benefit that receives too little attention is the return of capital.
The power of capital repayment
Apartment trustee Joe Fairless points out that there are “three immutable laws” of real estate investing:
- Buy to earn money [i.e., do not speculate on assets that will eat up cash]
- Insure long-term debt with low leverage [lower interest rate than private money PLUS principal paydown]
- Have sufficient liquidity reserves. [i.e., save for a rainy day and have the flexibility to jump on opportunities quickly]
The first law is not so much to earn so much with cash that you get rich. This is mainly to ensure that the asset is durable, that it does not eat away at your cash reserves (Law 3) and that it can sell for its highest market price. But when you add Law 1 to Law 2 (cash flow plus return of capital), your return is more than just the inflow of money.
Indeed, each bank loan is amortized. You pay interest and principal every month. And each principal payment reduces the amount of debt attached to the property.
While it doesn’t come back to you in hard cash, it does increase your net worth. And any real estate investor worth his salt knows that the key number to consider is equity.
To illustrate this point, I performed a simple calculation to show what the internal rate of return would be with only principal repayment. (The internal rate of return or IRR is greater than a simple ROI or ROI because it takes into account WHEN money is received; the sooner the better.)
Of course, this is not really a “return” since there is no money here, just equity. But the point should suffice. Here are the assumptions:
- Purchase price: $ 100,000
- Deposit: $ 20,000
- Loan: $ 80,000
- Amortization: 20 years
- Net cash flow: $ 0
- Appreciation: 0%
The last hypothesis is bordering on ridiculous. In the past 20 years, only one of the 500 largest cities in the United States has failed to rise in value (Flint, MI). And the housing crisis of 2008 occurred during this time.
Even still, if you were to simply own a property with a 20 year loan for the entire 20 years with no cash flow (the rent only paying for all expenses related to the property) and appreciation, the rate of return is pretty good. Using the CCIM financial calculator, we see the following:
7.18% may not sound amazing, but it’s not bad at all. Indeed, as Nerd Wallet reports, the average return on the stock market is only 10%. So the stock market barely beats the return of capital without any of the other real estate benefits!
There are a few caveats here. On the one hand, at the start of a loan, most of the payment goes to interest and then as you progress through the loan it changes and most of each payment goes to principal, as shown in l following example:
Therefore, if you prepay the loan, the IRR will be less. In addition, if the loan is amortized over 30 years as many are, the IRR will also be lower (although the cash flow will be higher).
But remember, this is a 7.18% return with no cash flow, no appreciation, no tax benefits, and just buying at market prices. Add these other benefits and the rate of return increases more and more.
The power to repay principal is another reason it’s not a good idea to sit on the sidelines and wait for a correction just because you think (rightly or wrongly) that the market is close to its bottom line. apogee. Of course, it’s important to be careful in a hot market like this. But there are so many advantages to real estate besides appreciation (the primary payoff being one of the most important and least discussed) that you shouldn’t just twiddle your thumbs and wait for a crash that can. or not happen at a time. can really predict.
Andrew Syrios has been investing in real estate for over a decade and is a partner of Stewardship Investments, LLC with his brother Phillip and father Bill. Stewardship Investments is focused on buying and holding and in particular the BRRRR strategy – buying, rehabilitating and renting homes and apartments throughout the Kansas City area. Today, Stewardship Investments has over 300 properties and 500 units. He writes for Think Realty, BiggerPockets and The Data Driven Investor.