Author Topic: Article: Why Real Estate Returns Are Higher than Stocks, Bonds and Mutual Funds  (Read 59520 times)

Bob W

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I'm sure the leveraged long term returns vs. nonleveraged would be astronomically higher.  Although, the risk is much greater as well.  The risk can be somewhat covered by being a good business manager, since owning real estate directly makes you a real estate manager. 

The benefit of looking 50-60 years down wind would be that you get to decide which of your grandchildren will assume ownership at your cost basis upon death.   Would be so nice to give the grandkids 30 rentals cash flowing 800 per month!

gimp

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I was sure too, until I did math. My models aren't complete because they account for neither compounding interest from returns, nor compounding interest from opportunity cost. So I'm not sure anymore. It's complex to account for all the variables, but it's definitely true that leverage has the downside of paying someone interest.

arebelspy

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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.

Leverage shouldn't give you negative cash flow.  You should have positive cash flow, even with leverage, and eve if your rents drop somewhat (i.e. have a buffer).

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.)

I'm a proponent of certain type of leverage.  The low interest, long term rates we have available today that are often less than inflation are pretty incredible.

I am leveraged about 33% LTV (i.e. my debt is about 1/3 the value of my properties, and about 66% equity) across my entire portfolio.  Some of my properties have mortgages.  Others I own free and clear.

It's very situational, and one should always run the numbers to see what makes sense for their given situation, even on a per property basis.
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johnhenry

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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.)

Do you mind to share your spreadsheet in progress?

I see where you are coming from, not wanting to get over-leveraged. 

I'm a fan of leverage (for my situation and goals).  I like to think I employ it strategically and conservatively.  For example, my RE portfolio includes 4 places that I've bought in 2012-2014 that are in the $40K - $45K range and rent from $625 - $700.  Point being, there are still places to be had that exceed the 1% rule, well after the housing crisis rebound.  These aren't places that were bough 12-15 years ago.  They are in the sweet spot you are talking about.

To me the question of how much leverage to employ depends on many factors.  One is how fast I want to grow this business/portfolio. Even though I'm FIRE, I'm young enough that my goals are focused on growth.  My thinking is.... I'll continue to employ leverage at least until I want to scale back growth.  At that point I can put positive cash flow towards paying down mortgages as opposed to more RE.  But since there's also a hedge against inflation provided by the cheap mortgages, I doubt that will happen, even when I put the business on cruise control (stop buying new properties and possibly put some under management, or even 1031 exchange into one larger asset or business that's easier to manage).

As a business owner, I worry very much about the worst-case scenario like the confluence of crappy events you describe.  But run the numbers on a $40K place that rents for $625 or a $45k place that rents for $700.  Consider the event(s) that would have to happen to drive the market rent rate from $625 to $400! and from $700 to $450!  And even in that unlikely circumstance, I'd still have investments meeting the 1% rule!  Even with $1000 of expenses factored, the rent would have to fall from $625 to $350 (or $700 to $410) before it went ever-so-slightly cash flow negative!  I'm not saying it can't happen.  But my business is built to withstand drops even worse than that for a prolonged period.  I would never take on so much leverage that, as a whole, the business couldn't survive for a couple years in terrible circumstances.

Notice that my worst-case scenarios, as a cash-flow investor, don't have anything to do with the market value of my assets, but only the market value of my rents.  If one of my properties loses half it's value on paper, and I have to reduce rent by 10-15% to keep tenants, I just keep moving.  Now, if (somehow) I have to reduce rents by 50% but the property has only lost 10-15%, I may consider selling and taking the loss.... if I think that scenario will persist for that property.

Combine that strategy with one that diversifies holdings to include properties in different states, parts of town, numbers of bedrooms, etc and you can reduce the likelihood that ALL properties would suffer at the same time.

Instead of looking for deals that "will always win" I look for deals that "will almost never lose", just because I share your respect for a worst case scenario and believe in preparedness.  But I still think it's wise for me to exploit leverage while it's cheap since my current goal is to grow my assets.

gimp

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Leverage can give you negative cash flow if, say, you suddenly can't find renters for whatever reason. On the plus side, it seems that the weaker the housing market, the stronger the renter's market, and vice versa - meaning that if there's a systematic issue with finding renters, selling the property will probably work out nicely.

The appeal to me of owning free and clear is not worrying about it. A good safety net - always have a place to live, just in case, you know?

After taking some more things into account and improving my models, I would say that for me, I want about 1.15% rent at 5% APR, or better rent / lower APR, to make it worth it. I can see why sub-4% APRs, especially closer to 3%, made houses incredibly attractive long-term. The main difference between buying stock and cash-flowing real estate at the bottom of the market is that index funds will tend to revert to normal (tripling in a few years is awesome but unsustainable), whereas once you've paid the very low price for the house, you're going to be getting a higher rent : price paid ratio forever.

Though I would probably re-run models every year to see expected results vs extractable equity right now. So if prices go up much more than expected, I'd want to just sell and find cheaper opportunity elsewhere for the same rent.

I do appreciate the time to answer my questions and respond to my thoughts, by the way. Many people would pay quite a few dollars for the opportunity.

gimp

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Quote
Do you mind to share your spreadsheet in progress?

Attached. I didn't want to link to google drive, but maybe later.

Assumptions are at the top. I'm using monthly compounding, so certain assumed % looks low - because I did the calculations in reverse; eg, if I want to assume 7% compounded yearly, that's around 6.8% compounded monthly.

I have four cases, in a matrix:
- 30y @ 5.5%; and 15y at 5.0%
- Breaking even, so I'm paying precisely the mortgage; and getting $600/month on the $50k property (around 1.2%), with the extra being paid down.

The models aren't complete, but it shows that I really want to at least break even on a 15y@5% mortgage (just under 600/month needed - around 1.15%). Reducing the interest means I can accept a slightly lower than 1.15% result; increasing the rent means I can accept a slightly higher interest rate.

Any glaring mistakes?

I've also compared against a 7%/year index, and I also assumed that any profit I extract once the house is paid off is invested at the same 7%/year index. It ignores variation in returns because I'm thinking long-term enough where I don't really care.

johnhenry

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Quote
Do you mind to share your spreadsheet in progress?

Attached. I didn't want to link to google drive, but maybe later.

Assumptions are at the top. I'm using monthly compounding, so certain assumed % looks low - because I did the calculations in reverse; eg, if I want to assume 7% compounded yearly, that's around 6.8% compounded monthly.

I have four cases, in a matrix:
- 30y @ 5.5%; and 15y at 5.0%
- Breaking even, so I'm paying precisely the mortgage; and getting $600/month on the $50k property (around 1.2%), with the extra being paid down.

The models aren't complete, but it shows that I really want to at least break even on a 15y@5% mortgage (just under 600/month needed - around 1.15%). Reducing the interest means I can accept a slightly lower than 1.15% result; increasing the rent means I can accept a slightly higher interest rate.

Any glaring mistakes?

I've also compared against a 7%/year index, and I also assumed that any profit I extract once the house is paid off is invested at the same 7%/year index. It ignores variation in returns because I'm thinking long-term enough where I don't really care.

Awesome! I'll admit some of the math is making my brain hurt :) 

Help me understand:

- in lay terms, how is the return column being calculated?
- I see the assumptions along the top, but none for monthly rent.  If this isn't a variable or constant, it's built in somewhere as an assumption, right?

- in the sheets with "profit" what do the 22 and 100 represent?  Is that extra monthly cash flow?  Do these models have that amount going to pay down extra on the mortgage? Or going somewhere else?


johnhenry

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Leverage can give you negative cash flow if, say, you suddenly can't find renters for whatever reason. On the plus side, it seems that the weaker the housing market, the stronger the renter's market, and vice versa - meaning that if there's a systematic issue with finding renters, selling the property will probably work out nicely.

The appeal to me of owning free and clear is not worrying about it. A good safety net - always have a place to live, just in case, you know?

I agree completely about the worst-case safety net.  After being in the business quite a while, I doubt I'll ever have to do it.  But knowing I have an asset that I can use for shelter for myself and family brings peace of mind.  But that can still be your safety net even if you have a mortgage on it, right?  That safety net sounds good, but if things got bad enough in the area I live (and also have a place that could house my family of 4), I'll have the option of moving into the rental if I can't keep it rented.... but then what do I do with my house?  Which I own.  It also has a mortgage, but I have much more equity in it than most of my rentals.  If enough shit was hitting the fan to force me to move, I'm not sure I'd be better off living in my $50K house, trying to sell/rent my $150K house, which would have no chance of meeting the 1% rule in my area.

About leverage and negative cash flow....  I'll grant you that the more you are leveraged, the faster you can go cash flow negative if you can't find a tenant.  And believe me, I worried about that when I was first getting started.  But if you are running a place that is extremely cash flow positive (i.e. well over 1%), it would take months of vacancy each year (or a much reduced rent) to generate negative cash flow over an annual period.  One metric I like to calculate for each deal I pursue is "breakeven occupancy" along with it's counterpart, "breakeven rent", where cash flow is concerned.  This gives me an idea of how bad things would need to get before I'd actually be cash-flow negative. 

Final point about negative cash flow.  Owning free and clear doesn't prevent negative cash flow if you can't find any tenants at all! I have places where the the mortgage payments are under $200/mo but the taxes and insurance combined are around $115.  There is risk in this business, to be sure.  But owning outright doesn't eliminate that risk.  It still costs money to own a home, even if you don't owe money on it.  I don't feel any better about a property sitting empty just because I own it free and clear.

You are "worried" about all the right things.  You are wise to prepare well for worst-case scenarios.

arebelspy

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About leverage and negative cash flow....  I'll grant you that the more you are leveraged, the faster you can go cash flow negative if you can't find a tenant.  And believe me, I worried about that when I was first getting started.  But if you are running a place that is extremely cash flow positive (i.e. well over 1%), it would take months of vacancy each year (or a much reduced rent) to generate negative cash flow over an annual period.  One metric I like to calculate for each deal I pursue is "breakeven occupancy" along with it's counterpart, "breakeven rent", where cash flow is concerned.  This gives me an idea of how bad things would need to get before I'd actually be cash-flow negative. 

Well said.

I could have about a 75% vacancy rate right now and break even after PITI, though any maintenance occurring on those other 25% would put me cash flow negative. If I use standard assumptions for that, I could have around 30% occupancy and cover everything, but have no cash flow for myself to live on.

Given I don't ever expect more than a 20% or so vacancy rate as a worst case scenario, I'm not too worried about being cash flow negative.

Even when multiple properties go vacant at once, which happens (due to variance and the law of large numbers), you want to be fine in that circumstance by having your other properties cover that (AND have large reserves on top of that).

Be smart, play it safe, but don't worry or lose sleep about it, just plan and prepare.
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gimp

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Help me understand:

- in lay terms, how is the return column being calculated?
- I see the assumptions along the top, but none for monthly rent.  If this isn't a variable or constant, it's built in somewhere as an assumption, right?

- in the sheets with "profit" what do the 22 and 100 represent?  Is that extra monthly cash flow?  Do these models have that amount going to pay down extra on the mortgage? Or going somewhere else?

Cool.

Return column is hard to describe in lay terms. Basically, you know how if you have a 5% return, your cash after 3 years is initial cash multiplied by (1 + 0.05) ^ 3? And if you compound monthly, it's initial cash multiplied by (1 + 0.05 / 12) ^ (3 * 12)?

So the return is the inverse of that. We start with a known initial cash, a known end result, a known time period, and do math to find out what the return must have been.

The monthly rent is assumed in break even cases to cover precisely double the fixed payments. That is, if I have to pay $250 ($150 interest, $50 principal, $50 tax) then I assume the rent is $500, because the other half covers management, maintenance, repairs, vacancy, insurance. It's fuzzy math, not one from actual case studies. Go with it. :)

"Profit" means that I am getting double the fixed payments + extra. EG, $100 profit means $500 + $100 = $600. $22 profit was actually the wrong number; if I assume the same fixed expenses as before, but a higher fixed payment, basically I made an oops when I was tired. I wanted to equalize the two as getting $600/month rent in the "profit" scenario - 1.2%. The "profit" models have the amount going to pay down extra on the mortgage, which is why that amount is considered part of the investment (money put in) to calculate return.

I appreciate your responses, john and reb. I have the strong suspicion that I may change my tune as I find myself more comfortable and with more properties. For _right now_, I want my first couple to be paid off asap.

johnhenry

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Help me understand:

- in lay terms, how is the return column being calculated?
- I see the assumptions along the top, but none for monthly rent.  If this isn't a variable or constant, it's built in somewhere as an assumption, right?

- in the sheets with "profit" what do the 22 and 100 represent?  Is that extra monthly cash flow?  Do these models have that amount going to pay down extra on the mortgage? Or going somewhere else?

Cool.

Return column is hard to describe in lay terms. Basically, you know how if you have a 5% return, your cash after 3 years is initial cash multiplied by (1 + 0.05) ^ 3? And if you compound monthly, it's initial cash multiplied by (1 + 0.05 / 12) ^ (3 * 12)?

So the return is the inverse of that. We start with a known initial cash, a known end result, a known time period, and do math to find out what the return must have been.

The monthly rent is assumed in break even cases to cover precisely double the fixed payments. That is, if I have to pay $250 ($150 interest, $50 principal, $50 tax) then I assume the rent is $500, because the other half covers management, maintenance, repairs, vacancy, insurance. It's fuzzy math, not one from actual case studies. Go with it. :)

"Profit" means that I am getting double the fixed payments + extra. EG, $100 profit means $500 + $100 = $600. $22 profit was actually the wrong number; if I assume the same fixed expenses as before, but a higher fixed payment, basically I made an oops when I was tired. I wanted to equalize the two as getting $600/month rent in the "profit" scenario - 1.2%. The "profit" models have the amount going to pay down extra on the mortgage, which is why that amount is considered part of the investment (money put in) to calculate return.

I appreciate your responses, john and reb. I have the strong suspicion that I may change my tune as I find myself more comfortable and with more properties. For _right now_, I want my first couple to be paid off asap.


I see.  Well, since you were kind enough to share a spreadsheet, I will share one too.  I tried to quickly clean it up a little and add some titles to each section.  Hopefully its useful to someone besides me.  Hopefully I didn't break any of the formulas during the rearranging.  It's one I use to quickly analyze potential deals based on purchase price, expected rent, and a few other variables.  Let me know if you have questions.

I'm interested to know if you ever adapt yours to include more variables/parameters.  And don't forget about the benefit of tax-deferred cash-flow through depreciation.

gimp

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That is a pretty cool spreadsheet. My income pushes me into a slightly higher tax bracket, but depreciation is nice and something I entirely ignored for now (as well as taxes in general.) I'll see about throwing them in.

arebelspy

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I see.  Well, since you were kind enough to share a spreadsheet, I will share one too.  I tried to quickly clean it up a little and add some titles to each section.  Hopefully its useful to someone besides me.  Hopefully I didn't break any of the formulas during the rearranging.  It's one I use to quickly analyze potential deals based on purchase price, expected rent, and a few other variables.  Let me know if you have questions.

I'm interested to know if you ever adapt yours to include more variables/parameters.  And don't forget about the benefit of tax-deferred cash-flow through depreciation.

Nice.  Maybe add a total return, counting the cash flow, tax benefits, and principal pay down (up to you if you also want to add an appreciation assumption)?
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.

aschmidt2930

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Some very interesting points all over the spectrum in this one. I have some skepticism into RE as most calculations I see never seem to be complete.  I'd be interested to see large data sets on what the margins on buying and renting really are after property taxes, interest on the initial loan (If applicable), repairs, periods of vacancy, insurance, ect are accounted for.

With that said, rental properties are absolutely a more consistent and safe form of income.  I currently own no rental properties, but the idea of having a check coming every month not dependent on dividend yields and price gains is appealing.