Author Topic: Article: Why Real Estate Returns Are Higher than Stocks, Bonds and Mutual Funds  (Read 59607 times)

totoro

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I forgot that was the original topic.  I expect we have arebelspy... 

Yes, Warren Buffet has done well.  His results are not easily repeatable.   

I'm not sure stocks are inferior.  They are less easily managed to optimal result by a mere mortal than real estate imo.

Your borrowing room is a natural cap on your ability to invest in RE.  Your good credit is an asset worth protecting.

lano

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I mean, what are the capital limits at which it becomes impossible to generate good profits in RE.

Mr. Buffet is still not paying out dividends while his company invests tens of billions of dollars.  Which means that he is still able to find good investment opportunities with those kind of money sums.

I assume that the real estate "investment" market is the total RE value of US minus all non investment properties.  Is that market enough for tens of billions of investment?  What are some of the biggest RE deals that occurred? 

Can Mr. Buffet sell his BRK stake tomorrow and start trading top city skyscrapers? 

What is the highest net worth of a person who only invest in RE? 


clifp

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You should be adding the principal pay downs to your down payment (initial equity).  So over time your ROE will also go down because your equity will grow and the returns will increase in dollar figure but decrease as a percentage.  So if you wanted to maximize ROE, you have to sell and buy somewhat frequently (maybe every 5-10 years or so) or refinance and reinvest the capital.

Naw that isn't right either..

Doing some Googling.  The formula is very simple. ROE  it is cash flow after taxes/initial cash investment.

In the example income is $24,000 expense are $13,730 = $10,270 before taxes benefits.
ROE = 10,720/25000 (down) = 41.1% which will change every years based on rent, and expenses but not principal repayment.

SDREMNGR

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Nope.   RoE definitely does change with paydown as well as changes in valuation.  That is your equity.  Your formula is just for calculating it on the 1st year. 

Think about it.  Your equity is your down payment less fees in the 1st year.  But your equity changes with both changes in your property's value and how much you have paid down the loan.  If you paid off the loan in year 2, your equity is now 100% and your ROE and ROI is the same. 

clifp

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Geez all this indexer on the forum and nobody has posted the "correct" answer.. :-)

Over the long term, On risk adjusted basis the return of real estate and stocks are the same.

Capital flows to asset classes that offer the best risk adjusted returns.

But risk matter a ton in this discussion.  The beta of real estate is historically much lower than stocks.
If you look at the Case Shiller chart from 1987 to 2005 there is hardly any volatility just a nice steady increase
http://us.spindices.com/indices/real-estate/sp-case-shiller-us-national-home-price-index.
If CS went back further we'd see more of the same I bet with a few 10-30% dips in some markets.

Now weird stuff happened between 2005 until about 2012.  The volatility of housing jump dramatically this in turn increased the perceived risk.
The higher risk meant higher returns.  This made stock guys like myself, Warren Buffett, and hedge fund managers take a look real estate, some of us for the first time. We took our money from stocks and started buying real estate.  Now that prices have risen real estate just doesn't look as attractive as it did back in 2011 and 2012. So I'll probably start shifting some back, and you no longer hear of hedge funds raising billions to invest in real estates.

The cash buyer of real estate is going to earn significantly lower returns than the cash buyer of stocks.  As you would expect, other than the once in lifetime events of the last few years,  real estate appreciates at the roughly the rate of inflation plus population growth. The cash buyer of real estate could have comfortably slept through the last crisis, perhaps had to lower rents modestly once or twice.   The road was a lot rockier for stock buyer since income is typical a much smaller component of returns than price appreciation and dividend cuts were pretty dramatic.
It is hard to ask risk though.   The real estate market is lot less efficient than the stock market so it is easier to find bargains.  You have to look at small cap stocks, and exotic debt instruments to be able find the same bargains a good RE can find.

However the typical real estate buyer employees leverage and the typical stock buyer doesn't.  Using leverage makes a ton of sense in real estate, and not a lot in equity investing except for in extraordinary circumstances.  My guess is that an real estate investor who puts 20 to 25% down on his property probably gets a higher ROE than stock investor. On the other hand somebody who had million dollars invested in RE in 2005-2007 and  borrowed 4 or 5 million more to buy 10 properties in say 2 or 3 market is probably broke right...  Where as the equity investor is worht more than $1 million.  Now will we see more risk in Real Estate going forward, I somewhat doubt it. 

Mr Mark

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Maybe we could use a worked example.



I would propose the following ( lets assume simple averages for year 1):

ROI = Revenue - maintenance and fees - tax , divided by cost of the asset, $125k,
       = $24,000 - 6000 - 1250  /   125,000   
      =  13.4%

But what is the return on equity?

ROE = Revenue - maintenance and fees - tax - interest, divided by net equity
       =  $24,000 - 6000 -1250 - 4920  /   ($25,000 - 1560)
      = 50%



I like this example and it illustrates the difference between ROI and ROE..  But I wonder if the ROE equation is correct. In about a dozen years the principal pay down  will exceed $25,000 and the ROE will turn negative.

well spotted. The roe equation should be
= 24000 - 6000 - 1250 - 4920  / (25000 + 1560)
= 44.5%

As noted, principal payment increases equity over time, reducing roe as net leverage decreases.

totoro

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I mean, what are the capital limits at which it becomes impossible to generate good profits in RE.

Mr. Buffet is still not paying out dividends while his company invests tens of billions of dollars.  Which means that he is still able to find good investment opportunities with those kind of money sums.

I assume that the real estate "investment" market is the total RE value of US minus all non investment properties.  Is that market enough for tens of billions of investment?  What are some of the biggest RE deals that occurred? 

Can Mr. Buffet sell his BRK stake tomorrow and start trading top city skyscrapers? 

What is the highest net worth of a person who only invest in RE?

What is your point?  Extrapolating a theory or making money?  I'm not too interested in the first without practical application so I'll leave it to others if they wish to respond.

totoro

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Geez all this indexer on the forum and nobody has posted the "correct" answer.. :-)

Over the long term, On risk adjusted basis the return of real estate and stocks are the same.

Capital flows to asset classes that offer the best risk adjusted returns.

But risk matter a ton in this discussion.  The beta of real estate is historically much lower than stocks.
If you look at the Case Shiller chart from 1987 to 2005 there is hardly any volatility just a nice steady increase
http://us.spindices.com/indices/real-estate/sp-case-shiller-us-national-home-price-index.
If CS went back further we'd see more of the same I bet with a few 10-30% dips in some markets.

Now weird stuff happened between 2005 until about 2012.  The volatility of housing jump dramatically this in turn increased the perceived risk.
The higher risk meant higher returns.  This made stock guys like myself, Warren Buffett, and hedge fund managers take a look real estate, some of us for the first time. We took our money from stocks and started buying real estate.  Now that prices have risen real estate just doesn't look as attractive as it did back in 2011 and 2012. So I'll probably start shifting some back, and you no longer hear of hedge funds raising billions to invest in real estates.

The cash buyer of real estate is going to earn significantly lower returns than the cash buyer of stocks.  As you would expect, other than the once in lifetime events of the last few years,  real estate appreciates at the roughly the rate of inflation plus population growth. The cash buyer of real estate could have comfortably slept through the last crisis, perhaps had to lower rents modestly once or twice.   The road was a lot rockier for stock buyer since income is typical a much smaller component of returns than price appreciation and dividend cuts were pretty dramatic.
It is hard to ask risk though.   The real estate market is lot less efficient than the stock market so it is easier to find bargains.  You have to look at small cap stocks, and exotic debt instruments to be able find the same bargains a good RE can find.

However the typical real estate buyer employees leverage and the typical stock buyer doesn't.  Using leverage makes a ton of sense in real estate, and not a lot in equity investing except for in extraordinary circumstances.  My guess is that an real estate investor who puts 20 to 25% down on his property probably gets a higher ROE than stock investor. On the other hand somebody who had million dollars invested in RE in 2005-2007 and  borrowed 4 or 5 million more to buy 10 properties in say 2 or 3 market is probably broke right...  Where as the equity investor is worht more than $1 million.  Now will we see more risk in Real Estate going forward, I somewhat doubt it.

You have hit on some of the differences and made a lot of good points, but I do not believe your statement that:

"Over the long term, On risk adjusted basis the return of real estate and stocks are the same."

is actually correct for rental property in good condition in a good area that is cash flow positive.

Appreciation, including on the leveraged amount, is not the only factor here.  Rental income needs to be accounted for as well in your comparison.

I think the best way to predict returns is to use a RE analyzer-type spreadsheet that accounts for all variables, (preferably including some of the hidden ones like lost opportunity costs on invested capital and your time).  You'll get the different measures, including the current and projected internal rate of return. 

My IRR is higher than 7% over the long-term and I'm not in a very good RE market.  I think most people could learn how to choose good properties fairly easily.  Not sure I could increase the long term stock returns past 7% easily or at all myself.  It seems like the average person cannot.

The reason that stocks might be more attractive to  individuals and investment companies and therefore "capital flows into them" is that the returns are acceptable and the management of RE is much more hands-on and dependant on individual attention to details than invest and leave it stocks.   RE is also much less liquid with higher costs of entry.

I think MMM captured the hands-on aspect in his review of owning rental properties: http://www.mrmoneymustache.com/2011/05/23/get-rich-with-owning-rental-houses/

arebelspy

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I'd probably side closer with clif, totoro, in that if you took out a fair wage for the time you put into finding properties, managers, learning about real estate, etc. etc. that IRR would be similar to stocks.  Stocks are much more passive, so naturally with real estate, if you know what you're doing, you'll do better, doing more work.  (Both sweat equity - physical labor - and mental equity from knowledge and network.)
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dragoncar

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I'd probably side closer with clif, totoro, in that if you took out a fair wage for the time you put into finding properties, managers, learning about real estate, etc. etc. that IRR would be similar to stocks.  Stocks are much more passive, so naturally with real estate, if you know what you're doing, you'll do better, doing more work.  (Both sweat equity - physical labor - and mental equity from knowledge and network.)

And if you know what you are doing, I'm guiding your time is worth more to potential employers.  I wonder what the extra return is on illiquid investments.

totoro

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You may be right in that, but if we apply that analysis we also have to apply the same analysis to those individuals for whom stocks and other instruments are a passion and who earn a higher return as a result.  Or to people who have gained expertise to allow them to learn a higher hourly wage or DIY things that others pay for.

How much time is spent reviewing background materials and analyzing a stock pick?  My guess is a fair bit for many and that it is ongoing if you are actively involved.  And my sense its that for those who do this it is not a chore but kind of fun and quite interesting.

For someone like me, stocks are not all that interesting, although they might become so once I understood more about them.  I'm interested enough in passive income to use the Canadian equivalent to Vanguard, but not interested enough yet to do the work that it would take to do more than that.   

I think the people that spend the time to get good at something have a passion for it.  I expect Warren Buffet can't wait to check up on companies.  He enjoys the thrill of finding the next good one and he cannot possibly need the money.

For me, real estate is also a hobby.  I enjoy seeing something work out as planned in a way that brings money and other benefits.  I like analyzing a deal.  I'm motivated to figure out how to make it work by figuring out what makes it work on multiple levels.

It is fun for me to turn my primary residence is something I live in with my family, pays for itself and keeps me occupied with interesting improvements.  Same with the vacation rental, it pays for itself, we use it ourselves regularly without any cost and it is a memory maker and refuge when I travel for work - I don't even need a suitcase. 

If we all started adding a dollar value to the time we spent on a hobby it would quickly seem like it was a worthless or less valuable use of time than it is.   Heck, we could all be earning money instead of posting here.

For me, it is about free time to do what I want and being able to spend it with the people I like to be with.  I happen to enjoy setting up events and systems that work for multiple reasons, and real estate is one of the things that matches that inclination.  Business development, cooking, home management, and dinner parties are some others that fit too. 

Now, if we are going to compare effort for return without looking at enjoyment and quality of life I guess it would be a mathematical exercise.  Life is not like that though.   We could all keep working for more money, heck, I could start working more for more money tomorrow, but I just don't want to.

So, as a mathematical comparison you might be right, although I'm not quite sure about that.  I'd have to do track my time to see. My view is that anything you spend your life's energy on justifies more than a mathematical analysis.

hodedofome

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My actual stock research takes about 5-10 minutes a day. Although I spend at least a few hours a day reading trading/investing/market history/psychology books to keep me continually learning and doing research on new systems. I enjoy it so it's what I do instead of watching tv or playing on the internet.

totoro

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My actual stock research takes about 5-10 minutes a day. Although I spend at least a few hours a day reading trading/investing/market history/psychology books to keep me continually learning and doing research on new systems. I enjoy it so it's what I do instead of watching tv or playing on the internet.

Real estate takes much less on specific research daily, and more time when evaluating a purchase, which for me is every couple of years.  I spend 30 min-one hour a day reading on real estate and business-related topics.  Almost all of this is online now.

clifp

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For me stocks are more interesting that real estate, now how much is because I have a much better knack for picking stocks than real estate I don't know.
While my timing is pretty good with real estate investing, the properties I buy tend not to appreciate as much similarly priced properties, in different neighborhoods. I also don't have a good feel for what improvement will produce the best ROI. I'm not sure I'll ever develop a feel for that.

You can be an above average stock investor by sticking with index mutual funds. I don't think there is a simple easy way to become an above average or even average real estate investor.

Most of the people I know that have done really well in RE have devoted  a lifetime to learning about 1 to 3 specific real estate markets.

I typically spend about an 1 or 2 before purchasing a stock, although that has expanded up to 30 hours over many, and much less time decide when to sell.  But I've never had a phone call from a stock about a flooded garage, or pigeons pooping.

arebelspy

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But I've never had a phone call from a stock about a flooded garage, or pigeons pooping.

I'm not understanding why you'd have gotten a call about that with your rentals, either.  That's what the property manager is for.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
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butchmonkey

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Property manager=active investment.

Costs matter.

arebelspy

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Property manager=active investment.

Costs matter.

I agree with both of those sentences, but I'm not sure what your point is.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
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clifp

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But I've never had a phone call from a stock about a flooded garage, or pigeons pooping.

I'm not understanding why you'd have gotten a call about that with your rentals, either.  That's what the property manager is for.

Property managers have to call you to get authorization for repair above a certain level,  home owner associations often will send the notifications to the home owner instead and/or addition to the Property manager.

hodedofome

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I don't know why ya'll are still arguing about this. Nobody is going to change anyone's entrenched beliefs here. To each his own. Now go out and slay the real estate or stock market of your choice.

Cheddar Stacker

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I don't know why ya'll are still arguing about this. Nobody is going to change anyone's entrenched beliefs here. To each his own. Now go out and slay the real estate or stock market of your choice.

Come on hoded, give it some time. Its only been 20 months since the OP. This topic just needs more time to evolve.

dragoncar

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I don't know why ya'll are still arguing about this. Nobody is going to change anyone's entrenched beliefs here. To each his own. Now go out and slay the real estate or stock market of your choice.

I changed my mind during this thread, but then I changed it back.

Franklin

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Quote
Come on hoded, give it some time. Its only been 20 months since the OP. This topic just needs more time to evolve.
...and the S&P is up about 40% since then, just out of spite.

Mr Mark

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Quote
Come on hoded, give it some time. Its only been 20 months since the OP. This topic just needs more time to evolve.
...and the S&P is up about 40% since then, just out of spite.

housing market up too, 10 - 40%. If you were mortgaged 4:1, that's a huge gain....

DoctorOctagon

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Over 40 years it's not possible to top the gains from holding good American businesses.  If you compare UNLEVERAGED real estate to UNLEVERAGED equity in S&P index fund or berkshire-hathaway, the stocks win hands down as you increase the time horizon.  If you leverage both, stocks just win harder, but most people don't play with margin.  It be scary :)

Scandium

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All fine and dandy, except (at least in my relatively low net worth case in an expensive area) it leads to a massive concentration of capital in a single unit in a single geographical area. Which might even be the same area where my job is located and my primary residence! Talk about risk concentration! Having ~50% or more of my net worth tied up to the fortunes of a 20 mi radius from my house? Not for me.

If buying a property would represent perhaps 10% of my net worth (unleveraged) then maybe, but for now I prefer to spread the risk over thousands of companies from all over the world.
« Last Edit: June 02, 2014, 03:07:55 PM by Scandium »

kyleaaa

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Geez all this indexer on the forum and nobody has posted the "correct" answer.. :-)

I did :)

Mr Mark

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Over 40 years it's not possible to top the gains from holding good American businesses.  If you compare UNLEVERAGED real estate to UNLEVERAGED equity in S&P index fund or berkshire-hathaway, the stocks win hands down as you increase the time horizon.  If you leverage both, stocks just win harder, but most people don't play with margin.  It be scary :)

agree, except for the last part.

a house in a solid place, that can rent out if required, with say 25% down, and you can leverage government subsidized with a fixed rate nominal loan, uncallable no matter underlying asset value, tax deductable interest and if you live there for 2 years in the last 5 capital gains tax free, with a rate for the debt at less than historic or projected long term market returns....

welliamwallace

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Even though it may be frustrating to hold these types of back-and-forth conversations, I just want to thank you all for taking the time, as reading this whole thread has taught me lots. These discussions have more value than just bragging rights, and for more than just the people participating!

Thanks all.

rmendpara

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Disagree with the premise.

Almost any chart over long time periods will show you that real estate barely outpaces inflation on a price basis. Income from the property will likely offset the financing costs and operating expenses, but this is just a small amount of compensation for the numerous risks (litigation, vacancy, highway being built right behind your backyard, etc) which you cannot control.

I will say that it is much easier to find market inefficiencies in real estate than it is in the public markets (stocks, bonds, etc), as it's relatively easy to understand, and based on cash flow projections and reasonable risk estimates, you can identify properties that are undervalued much more accurately than a stock/bond that is undervalued.

That said, I own a rental property and greatly appreciate the cash flow (paid off now) when I consider it as a portion of my overall NW. The $6k/yr (net of operating expenses) on a $95k gross investment in 2012 is definitely an anomaly, as today it would likely be $6k/yr on a $130k investment, which is a much lower return.

But, to my earlier point, to an experienced investor who understands RE, it's easier to generate alpha.

arebelspy

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Even though it may be frustrating to hold these types of back-and-forth conversations, I just want to thank you all for taking the time, as reading this whole thread has taught me lots. These discussions have more value than just bragging rights, and for more than just the people participating!

Thanks all.

Thanks for the positive post welliam.  Appreciate it!  :)
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

Mr Mark

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But, to my earlier point, to an experienced investor who understands RE, it's easier to generate alpha.

+1

Bob W

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That article has me convinced.   I have been "in real estate" for several years.  My favorite tax write off is my auto mileage.   It seems that most times I drive I am always looking at real estate.  I mean seriously, I can't help but look at for sale signs.   I even ask people constantly what they paid or what the asking price is for a property.   I even look on the internet for bargains.   

Bottom line -- I deducted about 12,000 miles on my taxes the last several years.   That netted me around $2,500 a year in tax savings.   

To feel confident on this write off in the event of an audit  -  I keep a mileage log (this also helps you reduce your driving) and I often snap photos of properties.  I sometimes even make voice notes on my phone.   Yes, I have a paper trail.   

And by the way,  if I find a property like the one mentioned in the article (25K in plus 20K restore and rents for $750) count me in.   Anytime I can make that sort of money, I'm seriously down for it!   

chesebert

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I evaluate my rentals as part of my investment portfolio and are therefore subject to period review based on IRR, NPV and efficient frontier analysis as compared to alternative investment in securities using net sales proceeds. So far the rentals are getting comparable risk-adjusted return as a basket of multi-class mutual funds. The one thing I really don't like about the rental investment is I am locked to the term of the lease agreement, and I can't sell the property during the term of the lease unless the buyer is also an investor, which limits the pool of buyers for the property. 

arebelspy

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I evaluate my rentals as part of my investment portfolio and are therefore subject to period review based on IRR, NPV and efficient frontier analysis as compared to alternative investment in securities using net sales proceeds. So far the rentals are getting comparable risk-adjusted return as a basket of multi-class mutual funds. The one thing I really don't like about the rental investment is I am locked to the term of the lease agreement, and I can't sell the property during the term of the lease unless the buyer is also an investor, which limits the pool of buyers for the property.

It's certainly less liquid, and more work. There are definite downsides.  Give that, if your risk-adjusted return is equal, I'd suggest you stick with mutual funds, or find better RE investments.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

Mr Mark

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I evaluate my rentals as part of my investment portfolio and are therefore subject to period review based on IRR, NPV and efficient frontier analysis as compared to alternative investment in securities using net sales proceeds. So far the rentals are getting comparable risk-adjusted return as a basket of multi-class mutual funds. The one thing I really don't like about the rental investment is I am locked to the term of the lease agreement, and I can't sell the property during the term of the lease unless the buyer is also an investor, which limits the pool of buyers for the property.

It's certainly less liquid, and more work. There are definite downsides.  Give that, if your risk-adjusted return is equal, I'd suggest you stick with mutual funds, or find better RE investments.

another post from the past! I think the original article is still en point. RE in the USA is a really unique opportunity,  IMHO. The way taxes work here is unbelievable.  A big slice of cash flowing RE in the stash is a huge enabler of a safe stable FIRE.

Now, our friends in Australia, UK, Canada, NZ, Germany, KL and Singapore probably have totally different numbers on this. Because in the end look at net after tax cashflow, and its impact on the whole portfolio.

 And quality rentals - as exemplified by early MMM - can enable you to withstand much greater volatility in your portfolio of stocks and bonds.

DrF

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I've been following this thread, and I want to throw my lot in with the stock crowd. It is much easier for an average investor to become FI through keeping their personal expenses low and putting 30-40-50% or more of their income into a low cost index fund. If the market goes down, it just means it is a good time to buy more, and that's what an average investor can do. While you are building your stash, you can keep on putting in your monthly deposit and eventually the market will reward you. Anything more than that and you have to develop quite a knowledge base before you can beat the market.

Now I turn to real estate. I think there are 2 camps here, those that have been burned and those that haven't. Both have happened to me, a little more burnt than not. I used to live in Nevada like arebelspy apparently does. I, unfortunately, am about 5-10 years older (I think, based on some of his posts). I say unfortunately because the second property I bought was a $311,000 condo in spring of 2005. By 2008 it was worth about 30% of that high. The same thing happened in Vegas, and much of the southwest. Well, if you were 5-10 years younger (arebelspy), and you start to look at real estate when you are 22-25 yo (around 2008/9 I would imagine) then things are looking really good. You can go out and buy a 2400 sqft house for $150000 that sold in 2005 for $500000. And wouldn't you know, it is cash flow positive from day 1. So, you buy a couple of these over 3-4 years and you think you are some real estate genius because you've made so much money, when if fact you just happened to come of age as a real estate investor at the bottom of the largest correction in over 50 years.

If you want to compare real estate to stocks, go out 50-70 years and see how equal they have been.  You haven't always been able to get a 4% mortgage for 30 years. Landlord costs used to be and soon will be much much higher, whereas stock market costs continue to decline.

Just a few thoughts, I'm not a hater. Congrats to arebelspy or anyone similar, you hit the real estate jackpot.

-DrFunk

gimp

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I was just working on a spreadsheet earlier though to calculate one's return with leverage, principal paydown, assuming $0 cash flow, and appreciation at the rate of inflation.  Was very interesting, and made me like RE even more as an investment, if that were possible.  :)

Well hello. This caught my attention, since I'm likely to pursue precisely this strategy when I jump into the deep end - I have no need for cash flow, and am much more interested in principal paydown. Long-term buy-and-hold except without needing or wanting to live off of rent income until maybe 30-40 years down.

Got that spreadsheet available to share?

Bob W

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Perhaps the biggest reason to own real estate as an investment is its inherent illiquidity.   

I had a friend that said money just ran through his fingers like water.   So he built his portfolio on rentals.   He couldn't sell them at the drop of hat or when the market went bad.   He has done very well.

Compare him to the average stock/bond investor.  (see another thread on this)  The average Joe is terrible and pulls their money out in down markets and buys in in up markets.   A huge, very high percentage of so called investors lose money in the market.  (something like 90%?)

Sadly,  even most MMM readers will do so.   The emotional pressures are huge.  So for those thinking that the market is better than rentals.  I'm pretty certain you're wrong.

Think of the stock market as a short term place to gather funds for future real estate purchases.

And perhaps the most important thing is to make your money going in on real estate.  Meaning buy distressed and below market properties only.  This takes patience and a daily look at your local market.

And don't forget to be cash flow positive from day one and  vette your renters intensely and keep your credit score sky high.

If you have to choose between 401Ks/IRAs and real estate rentals.  Choose the rentals.  They will have more tax advantages than the investment accounts.    You can even pass them along to your grandkids as inheritance at the basis purchase price.   And there is no mandatory withdrawal at age 72.
And there are no mandatory taxed dividends.   If you property starts cash flowing too much, simply refi and buy another property. 

Like everything else in life though,  it won't be easy.

   


arebelspy

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I was just working on a spreadsheet earlier though to calculate one's return with leverage, principal paydown, assuming $0 cash flow, and appreciation at the rate of inflation.  Was very interesting, and made me like RE even more as an investment, if that were possible.  :)

Well hello. This caught my attention, since I'm likely to pursue precisely this strategy when I jump into the deep end - I have no need for cash flow, and am much more interested in principal paydown. Long-term buy-and-hold except without needing or wanting to live off of rent income until maybe 30-40 years down.

Got that spreadsheet available to share?

Hmm, so I found the spreadsheet, and I have no idea what the fuck is going on in it.

Some documentation from past me would have been nice.

EDIT: Okay, I figured it out, there was just one superfluous column that had a 10% cash flow return that was being paid back down into the mortgage (it was assuming you didn't need the cash flow), but I had changed the spreadsheet halfway through to assume no cash flow, so that column wasn't doing anything or referenced anywhere, just confusing me with its existence.

Someone feel free to check my numbers.

Assumptions:
- Cash flow pays the mortgage payment, taxes, insurance, maintenance, vacancy, management, etc.  Overall property is "break even."
- 100k purchase price, 25k down, 75k financed @ 5.5%
- 3% inflation (and house appreciates at the rate of inflation).

In 10 years, house will be worth $134,391.64.  Loan balance will be $$61,763.64.  Equity is $72,628.00.

That is $54,042.05 equity in real dollars (backing up 10 years at 3%).  Putting 25k in for 10 years and getting 54k out gives you a real return of ~8% (11.25% nominal return).

So an 8% return just from using 5.5% leverage and breaking even on the cash flow (and assuming house appreciation = inflation rate), you'll make about 8% return.  Of course, that doesn't count transaction costs, but nor does it count tax benefits.

It's probably not worth buying a break even house, but if you're adding some decent cash flow on top of it...
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

DrF

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I was just working on a spreadsheet earlier though to calculate one's return with leverage, principal paydown, assuming $0 cash flow, and appreciation at the rate of inflation.  Was very interesting, and made me like RE even more as an investment, if that were possible.  :)

Well hello. This caught my attention, since I'm likely to pursue precisely this strategy when I jump into the deep end - I have no need for cash flow, and am much more interested in principal paydown. Long-term buy-and-hold except without needing or wanting to live off of rent income until maybe 30-40 years down.

Got that spreadsheet available to share?

Hmm, so I found the spreadsheet, and I have no idea what the fuck is going on in it.

Some documentation from past me would have been nice.

EDIT: Okay, I figured it out, there was just one superfluous column that had a 10% cash flow return that was being paid back down into the mortgage (it was assuming you didn't need the cash flow), but I had changed the spreadsheet halfway through to assume no cash flow, so that column wasn't doing anything or referenced anywhere, just confusing me with its existence.

Someone feel free to check my numbers.

Assumptions:
- Cash flow pays the mortgage payment, taxes, insurance, maintenance, vacancy, management, etc.  Overall property is "break even."
- 100k purchase price, 25k down, 75k financed @ 5.5%
- 3% inflation (and house appreciates at the rate of inflation).

In 10 years, house will be worth $134,391.64.  Loan balance will be $$61,763.64.  Equity is $72,628.00.

That is $54,042.05 equity in real dollars (backing up 10 years at 3%).  Putting 25k in for 10 years and getting 54k out gives you a real return of ~8% (11.25% nominal return).

So an 8% return just from using 5.5% leverage and breaking even on the cash flow (and assuming house appreciation = inflation rate), you'll make about 8% return.  Of course, that doesn't count transaction costs, but nor does it count tax benefits.

It's probably not worth buying a break even house, but if you're adding some decent cash flow on top of it...

Arebelspy,

You are using "best case scenario" input on some of your assumptions. How many years have people been able to get a 5.5% mortgage for an investment property? In the past 10 years (from today) has any home in the US appreciated at 3% per year? I would say definitely not in Las Vegas, or much of the southwest. I understand the power of leverage when it comes to real estate, but recent investment vehicles are now offering 3x leveraged index funds for < 1% annual fee (URTY, UMDD, TQQQ, UPRO, UDOW). So, if you want to compare leverage to leverage if we "assume" a 7% return on average for the S&P500 over a 10 year period (inflation already accounted for), if you were to have bought the 3x leveraged S&P500 (UPRO) you would have garnered a $143,187 profit over that period (assuming you started with the same principle of 25k). This example is also "best case scenario", but the longer you stay in the better fit your results would be to the expected result. As you can see, this blows real estate out of the water.

The thing with stocks is that when prices dip, the average investor has the means to keep adding to their position. This is not always the case if you own real estate. If you buy a rental property and prices drop locally by 10-15% many people would have no way of capitalizing on that sweet drop. Additionally, if another house that was an even better investment came on the market, the "average investor" would lose out because of the opportunity cost of already owning another property. Sure, if you had $100,000 sitting in a brokerage account somewhere you would have that opportunity. But, most who are planning to FIRE are using tax advantaged accounts that prohibit withdrawals.

You are drinking your own cool-aid because it has worked for you, congratulations! Just realize that if you had bought your first rental just 5 years earlier you would not be singing the same sweet tune.

All the best,

DrFunk

edited for spelling
« Last Edit: October 07, 2014, 11:11:05 AM by DrFunk »

arebelspy

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I disagree about using a best case scenario, I'm using a realistic one (appreciation at the rate of inflation, 5.5% mortgage rate).  Sure, historically 5.5% is a few percent lower than the average, but it's what we have right now, so it's relevant to someone investing right now.

As far as timing, you assume I would have bought 5 years earlier.  The people doing that were ones taking negative cash flow while speculating on appreciation bailing them out.  No thanks.  If one only buys when it cash flows, you don't have as much worry about buying in a bubble.

You stock market scenario has ridiculous amounts of risk, and very likely will get a margin call at some point in there, wiping you out.

I don't blindly trumpet "buy real estate" - I'm often advocating for people to NOT buy real estate in markets where it doesn't make sense - ask the Australia guys about that.

But the benefit of real estate is that it's an inefficient market - you can find deals.  Comparing certain real estate scenarios like those, it can make sense to buy real estate.  Lots of times it doesn't make sense though.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

DrF

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With the 3x leveraged funds you are not using margin - so there would never be a margin call. You are using only your own dollars. Investing in leveraged funds with dollar cost averaging for a period of 10+ years will have no greater risk than a vanilla S&P500 fund! This is what I am doing and will do well into FI. I won't even have to screen new tenants to boot.

The point I am trying to make here is that the last 5 years in the real estate market is an anomaly. To find the kind of over-correction that most of the US went through from 2006-2011 you would have to go back to the great depression. It has "historically" been much harder to make real estate work on the single property side of investing. That is why the average investor will have done much better in the stock market, and as real estate corrects, the stock market will continue to be the preferred avenue for wealth accumulation vs risk.

As you like to say though, YMMV.

arebelspy

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With the 3x leveraged funds you are not using margin - so there would never be a margin call. You are using only your own dollars. Investing in leveraged funds with dollar cost averaging for a period of 10+ years will have no greater risk than a vanilla S&P500 fund! This is what I am doing and will do well into FI. I won't even have to screen new tenants to boot.

With 3x leveraged funds, decay eats you alive and you lose hard.

The point I am trying to make here is that the last 5 years in the real estate market is an anomaly. To find the kind of over-correction that most of the US went through from 2006-2011 you would have to go back to the great depression. It has "historically" been much harder to make real estate work on the single property side of investing. That is why the average investor will have done much better in the stock market, and as real estate corrects, the stock market will continue to be the preferred avenue for wealth accumulation vs risk.

The last 5 years were great for RE, but they were also great for stocks.

There is always opportunity in real estate, I believe, but you have to have the knowledge to take advantage of it.

Index funds certainly doesn't require that, and is a better choice for many.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

DrF

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With the 3x leveraged funds you are not using margin - so there would never be a margin call. You are using only your own dollars. Investing in leveraged funds with dollar cost averaging for a period of 10+ years will have no greater risk than a vanilla S&P500 fund! This is what I am doing and will do well into FI. I won't even have to screen new tenants to boot.

With 3x leveraged funds, decay eats you alive and you lose hard.



http://seekingalpha.com/article/1457061-how-to-beat-leveraged-etf-decay?page=2

Long leveraged ETFs are completely viable, and in up markets they provide near "exponential" returns.


johnhenry

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I was just working on a spreadsheet earlier though to calculate one's return with leverage, principal paydown, assuming $0 cash flow, and appreciation at the rate of inflation.  Was very interesting, and made me like RE even more as an investment, if that were possible.  :)

Well hello. This caught my attention, since I'm likely to pursue precisely this strategy when I jump into the deep end - I have no need for cash flow, and am much more interested in principal paydown. Long-term buy-and-hold except without needing or wanting to live off of rent income until maybe 30-40 years down.

Got that spreadsheet available to share?

Hmm, so I found the spreadsheet, and I have no idea what the fuck is going on in it.

Some documentation from past me would have been nice.

EDIT: Okay, I figured it out, there was just one superfluous column that had a 10% cash flow return that was being paid back down into the mortgage (it was assuming you didn't need the cash flow), but I had changed the spreadsheet halfway through to assume no cash flow, so that column wasn't doing anything or referenced anywhere, just confusing me with its existence.

Someone feel free to check my numbers.

Assumptions:
- Cash flow pays the mortgage payment, taxes, insurance, maintenance, vacancy, management, etc.  Overall property is "break even."
- 100k purchase price, 25k down, 75k financed @ 5.5%
- 3% inflation (and house appreciates at the rate of inflation).

In 10 years, house will be worth $134,391.64.  Loan balance will be $$61,763.64.  Equity is $72,628.00.

That is $54,042.05 equity in real dollars (backing up 10 years at 3%).  Putting 25k in for 10 years and getting 54k out gives you a real return of ~8% (11.25% nominal return).

So an 8% return just from using 5.5% leverage and breaking even on the cash flow (and assuming house appreciation = inflation rate), you'll make about 8% return.  Of course, that doesn't count transaction costs, but nor does it count tax benefits.

It's probably not worth buying a break even house, but if you're adding some decent cash flow on top of it...

Arebelspy,

You are using "best case scenario" input on some of your assumptions. How many years have people been able to get a 5.5% mortgage for an investment property? In the past 10 years (from today) has any home in the US appreciated at 3% per year? I would say definitely not in Las Vegas, or much of the southwest. I understand the power of leverage when it comes to real estate, but recent investment vehicles are now offering 3x leveraged index funds for < 1% annual fee (URTY, UMDD, TQQQ, UPRO, UDOW). So, if you want to compare leverage to leverage if we "assume" a 7% return on average for the S&P500 over a 10 year period (inflation already accounted for), if you were to have bought the 3x leveraged S&P500 (UPRO) you would have garnered a $143,187 profit over that period (assuming you started with the same principle of 25k). This example is also "best case scenario", but the longer you stay in the better fit your results would be to the expected result. As you can see, this blows real estate out of the water.

The thing with stocks is that when prices dip, the average investor has the means to keep adding to their position. This is not always the case if you own real estate. If you buy a rental property and prices drop locally by 10-15% many people would have no way of capitalizing on that sweet drop. Additionally, if another house that was an even better investment came on the market, the "average investor" would lose out because of the opportunity cost of already owning another property. Sure, if you had $100,000 sitting in a brokerage account somewhere you would have that opportunity. But, most who are planning to FIRE are using tax advantaged accounts that prohibit withdrawals.

You are drinking your own cool-aid because it has worked for you, congratulations! Just realize that if you had bought your first rental just 5 years earlier you would not be singing the same sweet tune.

All the best,

DrFunk

edited for spelling

Your examples and your investment history prove that you don't understand the importance some of us place on investing for cash flow.  If I have a property that provides substantial cash flow, I'm not worried at all if the market value of that income-producing asset falls.... because I'm not selling!  In the midwest, I have more than one property that's appreciated at 3% per year over the past 10 years.  But that's irrelevant to me.  I own the properties because they make me money each year and the increased risk compared to index fund investing is worth the increased return.

And you don't need $100K in liquid, taxable funds to move quickly on a great real estate deal.  Nevermind that real estate prices move slowly, anyway.  But if the right deal comes along, a 15-20% down payment + closing costs is all you need.  My income from wages is WAY lower than many on this forum, but I've been able to have enough cash on hand to snap up what I thought were good deals in RE even after owning multiple properties.  Yes, it's true, running a business that produces significant cash flow can provide cash reserves that can be re-invested if the right deal comes along :)


dragoncar

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With the 3x leveraged funds you are not using margin - so there would never be a margin call. You are using only your own dollars. Investing in leveraged funds with dollar cost averaging for a period of 10+ years will have no greater risk than a vanilla S&P500 fund! This is what I am doing and will do well into FI. I won't even have to screen new tenants to boot.

With 3x leveraged funds, decay eats you alive and you lose hard.



http://seekingalpha.com/article/1457061-how-to-beat-leveraged-etf-decay?page=2

Long leveraged ETFs are completely viable, and in up markets they provide near "exponential" returns.

I read that article and while interesting, I don't think it supports your assertion of "completely viable"

That said, isn't there an easier way to accomish a leveraged long play with LEAPS options or similar?  Anyone have a strategy to share?

hodedofome

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Index futures can give you 6-10x leverage with no interest, just trading commissions. You'll want to check the margin requirements however, and understand that margin requirements are not static. They can and do change, usually at the worst time for your account.

gimp

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Assumptions:
- Cash flow pays the mortgage payment, taxes, insurance, maintenance, vacancy, management, etc.  Overall property is "break even."
- 100k purchase price, 25k down, 75k financed @ 5.5%
- 3% inflation (and house appreciates at the rate of inflation).

In 10 years, house will be worth $134,391.64.  Loan balance will be $$61,763.64.  Equity is $72,628.00.

That is $54,042.05 equity in real dollars (backing up 10 years at 3%).  Putting 25k in for 10 years and getting 54k out gives you a real return of ~8% (11.25% nominal return).

So an 8% return just from using 5.5% leverage and breaking even on the cash flow (and assuming house appreciation = inflation rate), you'll make about 8% return.  Of course, that doesn't count transaction costs, but nor does it count tax benefits.

It's probably not worth buying a break even house, but if you're adding some decent cash flow on top of it...

Cool. I played with some numbers and came to some very interesting conclusions... such as your return % decreasing over time. After the loan is paid off, I can see why the % would decrease over time (profit isn't reinvested); however, I'm quite curious about whether it's normal during the loan term.

Using your numbers for example: 10 years, equity is 72.5k, 25k down, 11.25% nominal.

30 years, the loan is paid off, equity == house value == 243k, 7.9% nominal.

In short, am I missing something because I made a mistake in assumptions, or is this real behavior?

arebelspy

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Yes, this is correct, though I bet you'll actually do better over time due to transaction costs being a smaller percentage of profit (though the same percentage overall).
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

gimp

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Makes sense.

The numbers I ran show a much more pessimistic view of a break-even house than I thought. They also showed that it made sense, for example, to add some of my own cash (negative cash flow) for long-term returns. That part makes sense since I don't particularly care about cash flow as long as it's not sinking too much of my money. This, along with my preference to not leverage too much, confirms my desire to focus on a smaller number of paid-off houses than a larger number of leveraged ones, even if the returns are smaller; I'm more than happy to go 100% stock index funds because their ups and downs won't matter until I sell, but I don't want as much leverage as you're comfortable with because I don't want a confluence of crappy events to leave me with a bunch of negative cash flow that I didn't sign up for.

They also showed that, for example, a house at $50k renting for $600/month, especially if I add another $100 of my own, is a very good long-term (~40 year) investment. In other words, 1% is dandy, 1.15% is excellent, much more than I thought before I ran numbers.

I need to fix up my model by assuming compounding interest on the returns (so after the house is paid off and is cash flowing); because anything I invest in funds has compounding interest and dividend reinvestment. I think I will see a big benefit from that.

Out of curiosity - I know you're a big proponent of leverage. Have you done the math to show 40- or 50- or even 60-year returns using your leverage strategy versus one that uses much less? Do you care? (I feel like I've read you saying that you'd likely divest yourself by the time you got to those lengths of time, making the question moot.)