Author Topic: Maybe I'm thinking of returns the wrong way  (Read 2996 times)

Bearded Man

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Maybe I'm thinking of returns the wrong way
« on: October 16, 2015, 04:42:14 PM »
I know a lot of the popular blogs on REI talk about how important cash flow is, but I've seen some investors that talk about equity plays as long as there is SOME positive cash flow, etc.

The reason I ask is because while I paid 64K cash for a old house 5 years ago and make about $700 a month after expenses, not counting appreciation, I make considerably more on a 300K house I bought a year ago, even though it is mortgaged and doesn't have the same amount of cash flow. After expenses, there are about $300 in cash flow, but another $350 in principal payment which is still going to my asset column. When you factor that in, it brings me up to $650 in money that goes to my asset column every month.

Furthermore, this doesn't count appreciation or depreciation. I live in a high appreciation area, so I could consider it, but for this example, let's pretend that it's not being taken into account that I get far more appreciation returns on a 300K house than I do on a house that is worth 150K now. For 70K invested, my house went up 35K last year. On the paid off house that is worth about half, I saw about 10K.

However; lets take into account that the depreciation benefit is better on the expensive house, and that more of the income is shielded from taxes due to the tax benefits of the expenses and the depreciation. That brings me up to $819, once I factor in depreciation.

But wait, I'm not done. Although the majority of a monthly rental payment on this house goes to pay the mortgage and expenses, once it is paid off courtesy of my tenants, the profits sky rocket. And I'm still in for 70K (use tenants money from rents to pay for upkeep). And all that time they've been adding money into the savings account called a house for me, but once it is paid off, it is mostly spendable (read that investable) cash rather than money going to principal, etc.

Point is, even if the returns on a property are only 11 or 12 % in my area on a house such as this, it is still a better return than in the market, and is not even taking into account depreciation or appreciation, not to mention the fact that over time, more money goes to my asset column, and eventually it will be paid off. It's still a good thing to buy for the long run, even if it doesn't provide AS MUCH benefit to me now as some of those cash flow cities in the Midwest where you can buy a house for the price of a VCR and rent it out for $1,500 dollars...



DaveR

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Re: Maybe I'm thinking of returns the wrong way
« Reply #1 on: October 16, 2015, 05:07:15 PM »
You are thinking of it the wrong way. Or at least not comparing apples to apples. Comparing leveraged vs unleveraged assets means that they won't match up. You need to compare cash-on-cash returns under the same capitalization structure.

And 11-12% annualized returns doesn't come without risk.

Bearded Man

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Re: Maybe I'm thinking of returns the wrong way
« Reply #2 on: October 16, 2015, 05:21:17 PM »
You are thinking of it the wrong way. Or at least not comparing apples to apples. Comparing leveraged vs unleveraged assets means that they won't match up. You need to compare cash-on-cash returns under the same capitalization structure.

And 11-12% annualized returns doesn't come without risk.

CoC return is CoC return. It's how much money you make on the asset whether you bought it outright or financed it. The gain on the house is typically going to be the same, but with leverage, you are making more money per dollar invested.  I am comparing apples to apples. If I calculated cap rate and compared it to CoC return, THAT would not be an apples to apples comparison. With CoC return, I'm getting an accurate percentage of how much money I'm making per dollar invested, regardless of whether it is financed or not. Here is some info on how to calculate basic cap rate and CoC returns, and when it is appropriate to do each and what they mean: http://www.biggerpockets.com/renewsblog/2014/05/10/cap-rates-cash-cash-returns-explained/

The point was that, even though I can't find houses at the prices of yesteryear in my area anymore, it's still a very profitable venture, especially in the long run, due to leverage.
« Last Edit: October 16, 2015, 05:33:06 PM by Bearded Man »

DaveR

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Re: Maybe I'm thinking of returns the wrong way
« Reply #3 on: October 16, 2015, 05:59:33 PM »
CoC return is CoC return. It's how much money you make on the asset whether you bought it outright or financed it. The gain on the house is typically going to be the same, but with leverage, you are making more money per dollar invested.  I am comparing apples to apples. If I calculated cap rate and compared it to CoC return, THAT would not be an apples to apples comparison. With CoC return, I'm getting an accurate percentage of how much money I'm making per dollar invested, regardless of whether it is financed or not.

The point was that, even though I can't find houses at the prices of yesteryear in my area anymore, it's still a very profitable venture, especially in the long run, due to leverage.

Typing fast and not explaining myself too clearly. Agree, there are still opportunities to be had and long-term profitability (with sensible leverage).

When I was thinking apples-to-apples, I meant factoring in leverage.

$35k gain on a $300k asset -> 35/300 = 11.6%increase
$10k gain on a $65 asset -> 10/65 = 15.4% increase

Which is a better?

And I wasn't talking cap rate, but rather financing (debt vs equity). It wasn't the right word (more of an accounting "capital cost") meaning.

Where I was going:

$70k equity in a $300k asset -> 70/300 = 23%
$35k increase on $70k investment -> 35/70 = 50%

with the same leverage on the $65k asset: .23 * 65 = $15.2k
$10k increase on $15.2k investment -> 10/15.2 = 65.8%

Which is better?

Your financing decisions have an impact on your returns. CoC is what it is...it's just that you can choose the "on cash" part.

clarkfan1979

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Re: Maybe I'm thinking of returns the wrong way
« Reply #4 on: October 16, 2015, 06:59:02 PM »
I would rather make $1000/month on one rental than $1,200 on three different rentals. Three rentals is going to be more work even with property management because I still need to have a strategy.

SwordGuy

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Re: Maybe I'm thinking of returns the wrong way
« Reply #5 on: October 16, 2015, 07:32:27 PM »
I would rather make $1000/month on one rental than $1,200 on three different rentals. Three rentals is going to be more work even with property management because I still need to have a strategy.

Yes, but in a different month, your choice might be $0/month on one rental and $800/month on 2 out of 3 rentals... :)

K-ice

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Re: Maybe I'm thinking of returns the wrong way
« Reply #6 on: October 16, 2015, 09:08:17 PM »
What if you put no money down?

Let's say a 100K place.

You borrow 25K from your primary residence HELOC as a down payment.

Mortgage the rest 75K on the rental property itself.

Does your ROI go to infinity? ;)



mr_orange

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Re: Maybe I'm thinking of returns the wrong way
« Reply #7 on: October 17, 2015, 10:32:23 AM »
You have to count all 4 areas that generate return in real estate:

1.  Appreciation - This should be hoped-for and is really only returned at the terminal cash flow or when you exchange into another asset.  The latter technique is preferred by many investors because it will allow you to avoid the taxes on the gains

2.  Depreciation - This is an especially big deal as your income grows.  I spend pretty much most of my effort now reducing taxes, which are my biggest expense BY FAR

3.  Cash flow - Make sure you include ALL expenses like capex, economic vacancy, etc.  Expenses generally consume about 45-50% of all operating cash flows for most projects.  See this discussion for more detail: http://www.johntreed.net/positive.html

4.  Principal reduction (If property is leveraged) - This again will only translate to a real cash flow at the reversion cash flow or when you exchange

The way you calculate returns should include the time value of money.  Appreciation and principal reduction will only generate real cash flows when you sell, exchange, refinance, etc.  So the way you calculate returns needs to have a full model applied with accurate cash flows which can then be translated to an IRR.  This is more important for projects that will be held longer. 

I could go on and on and on about this topic.  Do some reading on Biggerpockets.com for more details.  There are literally thousands of good threads on this.  The appreciation versus cash flow topic gets debated endlessly and posters on both sides generally fail to see that people invest differently for different purposes.  What is best for you may not be best for the next person with different goals, initial conditions, access to capital, etc. 
« Last Edit: October 17, 2015, 03:59:11 PM by mr_orange »

Bearded Man

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Re: Maybe I'm thinking of returns the wrong way
« Reply #8 on: October 17, 2015, 03:45:31 PM »
You have to count all 4 areas that generate return in real estate:

1.  Appreciation - This should be hoped-for and is really only returned at the terminal cash flow or when you exchange into another asset.  The latter technique is preferred by many investors because it will allow you to avoid the taxes on the gains

2.  Depreciation - This is an especially big deal as your income grows.  I spend pretty much most of my effort now reducing taxes, which are my biggest expense BY FAR

3.  Cash flow - Make sure you include ALL expenses like capex, economic vacancy, etc.  Expenses generally consume about 45-50% of all operating cash flows for most projects.  See this discussion for more detail: http://www.johntreed.net/positive.html

4.  Principal reduction (If property is leveraged) - This again will only translate to a real cash flow at the reversion cash flow or when you exchange

The way you calculate returns should include the time value of money.  Appreciation and principal reduction will only generate real cash flows when you sell, exchange, refinance, etc.  So the way you calculate returns needs to have a full model applied with accurate cash flows which can then be translate to an IRR.  This is more important for projects that will be held longer. 

I could go on and on and on about this topic.  Do some reading on Biggerpockets.com for more details.  There are literally thousands of good threads on this.  The appreciation versus cash flow topic gets debated endlessly and posters on both sides generally fail to see that people invest differently for different purposes.  What is best for you may not be best for the next person with different goals, initial conditions, access to capital, etc.


IRR if I recall correctly from undergrad and a fairly recent MBA class, is a good way to indicate the ideal holding period of an asset, from the reading anyways. I will look into that.

mr_orange

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Re: Maybe I'm thinking of returns the wrong way
« Reply #9 on: October 17, 2015, 04:06:52 PM »
The "ideal holding period" from a ROE standpoint may not align with your goals.  If your goal is to reduce effort exerted, deleverage, and live on the cash flow from free-and-clear property then your optimal sell year will come FAR before when you should sell if you include these assumptions.  There are various arguments for and against leverage, but having less of it generally will make you lazier and less vigilant about making the portfolio perform optimally. 

There are several giant spreadsheets on the files section of biggerpockets.com that do some pretty elaborate analysis on property cash flows.  What you'll find if you tune all of this stuff is that the dominant variables that drive sensitivity are things like economic vacancy, rent rates, etc.  A lower economic vacancy will generally be obtainable with lower rents and vice versa.  It is harder to rent properties for higher rents when there is a competitive market. 

In general I am a big believer that your leverage ratios should go down as you age.  You'll be less likely to be able to absorb losses as you near the time when you need to access the money you've accumulated.  The corollary is that you should have higher leverage ratios when you're young.  This, of course, needs to be balanced against having positive cash flow and liquidity.  The latter gives you staying power and is pretty much the hardest thing that real estate investors have to manage.  Developers or property owners are notoriously asset rich and cash poor. 
« Last Edit: October 20, 2015, 07:15:04 PM by mr_orange »

mr_orange

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Re: Maybe I'm thinking of returns the wrong way
« Reply #10 on: October 17, 2015, 04:11:26 PM »
Another article you may consider reading is this one from my friend Ray Alcorn:

http://www.creonline.com/cap-rate-formula.html

This is one of the best articles I have ever seen about how to work things in the real world.  This is really more centered around acquisitions decisions though.  There are better resources on biggerpockets.com for fully accounting for returns of projects in your portfolio.  Ray's Dealmaker's Guide To Commercial Real Estate is a great resource if you're an aspiring real estate investor too.  The materials are expensive, but they're the best in the business.   

DaveR

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Re: Maybe I'm thinking of returns the wrong way
« Reply #11 on: October 17, 2015, 06:13:24 PM »
That is a good read.

A nice little nugget: In short, before accepting the NOI presented, understand what is behind the numbers. This is known as "normalizing" the numbers. You can also tweak the numbers to reflect the way you will own and manage the property.

Decide to defer maintenance and slum lord it up... viola! incredible returns. I think the biggest thing is that numbers can be deceptive. An investor has to know his goals and be conscience of how decisions impact those goals. Cash flow, appreciation, leverage, risk...all subjective. What works for me almost certainly doesn't work for you.