After a workload-induced two week hiatus from writing, I’m back to answer one very frequently asked question. What is the return on investment when you execute the Blueprint real estate investing strategy?
Investors that ask that question are usually trying to compare and contrast investments in different asset classes (stocks, bonds, commodities, life insurance, real estate etc) to make an allocation decision. After all, every investor has a finite amount of hard earned (even harder saved) capital and the quality of their retirement depends in large part on their decision to invest that money wisely.
The final decision depends on four things: The return on investment, the risk involved, the investor’s tolerance for risk and her available investment timeframe. If the investment offers a sky high rate of return but there’s a good chance to lose all your principal, you might want to pass if you have a low tolerance for risk (or possess common sense). If instead, the principal is relatively safe but the return on investment looks up to inflation, you better hope your accumulated capital is enough to hold you as you cannibalize it in your retirement years. Last but not least, the direction you take in your investing is very different if you are 20 years or 24 months away from retirement.
Put a different way, it’s crucial to strike the right risk-return-timeframe balance. And that’s much easier said than done.
Having said that, the question is a fair one. Inquiring minds want to know: If you invest a dollar of capital in a quality asset and hold it long term what should you expect your return to be on that dollar? Real estate investments have the potential to “make the investor money” from four different sources.
Cash on Cash
Cash on cash returns are the perennial investor favorite: Simple and to the point, easy to understand and relatively reliable. The cash on cash return on investment is calculated as the positive cashflow produced by the property (after paying for operating expenses and mortgage payments) divided by the cash investment in the property (down payment and closing costs). Think about it this way – the positive cashflow is the “interest” (or dividend) paid by the investment on your cash invested. When we analyze investment properties for acquisition daily, the projected before tax cash on cash return for each property has to be at least 12%. And this is after we take a conservative approach on incoming rent and operating expenses so in many cases your actual return ends up being higher than what’s in our cashflow projections.
A close cousin to the cash on cash return is the capitalization (or cap) rate. This is the rate of return earned by an investor that owns the property free and clear. For quality locations in good school districts with high tenant demand, we are seing capitalization rates in the 8-9.5% range.
Debt Amortization
Although the cash on cash return is easy, it’s incomplete because it does not account for other returns/benefits the investor receives besides the positive cashflow. One of these benefits is the debt amortization (pay-down) as the investors’ mortgage is paid every month using the incoming rent from the property. It’s easy to forget about this portion of the return since the investor doesn’t “see” this money until the property is sold later on. But that’s more a question of style over substance. Let’s say you acquire an investment property with $100k mortgage at 4% for 30 years. Your positive cashflow at the end of the year is $4700 (a 12% return). During that year, while you were enjoying your “dividend”, your mortgage balance is also paid down by $1761 which amounts to an additional 30% of that annual cashflow.
Capital Appreciation
Ah the good old “A Word” – something one ought not dare use lest they be accused of blasphemy. From 2008 on, disillusioned investors that had been counting on appreciation to right all their fundamental investing wrongs received a pretty harsh punishment from a market that had been pushed passed it’s inflation limit. It turns out that real estate cannot appreciate at 20% annual rates in perpetuity. Who knew?
When you purchase a long term investment property to hold, you effectively control that property and can reap the benefits of appreciation (when and if it happens) which could propel your returns even higher. While a real estate investment strategy that relies solely on appreciation is as flawed as last time it was tried, a more grounded approach that relies on solid positive cashflow and treats appreciation as a additional bonus return is the way to go. But since appreciation is less reliable than Lindsey Lohan on a film set – no one really knows when and if it’s coming, we assume no appreciation on our analyses. If it happens, I don’t think you’ll be very upset with me either way.
Tax Benefits
Finally, real estate investments are afforded special tax treatment in two ways by the IRS which indirectly contributes to your overall return. First, they allow you to take a ghost expense called depreciation, therefore making your cashflow for tax purposes appear smaller than what it was in real life. In so doing, they allow the investor to pay tax on that income at a much lower tax bracket than would have been the case with ordinary earned income. And second, they allow the investor to defer capital gains taxes on the sale of an investment property by rolling the proceeds into the purchase of another investment property. That’s a treatment not afforded to any other investment.
The comprehensive return on investment figure that accounts for all the four factors discussed above is the internal rate of return (IRR). In general, the properties that our clients are buying have IRRs in the 16% range – without accounting for any appreciation during the investment timeframe.
The Wrong Question
I hope that answered your question because I’m here to tell you that it’s a misdirected question altogether. Wall Street has conditioned us to be return centric and compare returns at the watercooler at work. But it’s all inconsistent with the number one rule of investing: Don’t lose the money! Tell me, what use is it to earn double digit returns consistently for years, only to see your principal ravaged by 40% in a major correction? As my mentor and friend Jeff Brown often says, investing is as much about return of investment as it is about return on investment.
Here’s a better measure of performance that aligns with your investing purpose. How about: Will your investment portfolio produce the income you desired when you started investing? If for every dollar you put in, you now own $3-4 in wealth 10-15 years later all while earning a great income, would you care what your percentage return actually was during that period? Take your Wall Street provided blinders off and focus on what’s in it for you. If your investing strategy produced the results you hired it to do, that’s true success.
Ralph Unden via Compfight