It’s important to have a good strategy
Like any investment, real-estate is not a sure thing.
Many of our clients have built or enhanced their net worth through smart real estate investments. Given that the majority of our clients live in the Bay Area this makes sense as real estate values, despite a short-lived downturn, have in general grown quite rapidly over the past 3 decades.
However like any investment, real estate is not a sure thing and it’s important to have a good strategy when either analyzing current real estate investments or considering your first investment in this area.
Let’s first consider 2 different property types for investment: Cash Flow vs. Appreciation
Cash flow properties are generally designed to carry little debt and produce annual net rental income in the 4%-9% range. Let’s take a look at an example – I buy a duplex for $500,000 and I put $400,000 down, taking a 30 year fixed mortgage for the remaining $100,000. To keep things simple, let’s assume no improvements are needed.
I then rent out each side of the duplex for $1,500 per month per tenant. My gross rent = $36,000. Assume my mortgage plus property taxes and insurance = $1,200 per month, or $14,400 per year. Let’s assume another $2,500 per year for maintenance and repairs. So my gross rent = $36,000 and my total expenses = $16,900, producing a net rent of $19,100. Take $19,100 divided by $400,000 (my equity) and we have a yield of 4.78%.
The rent is not fully taxable because I have some offsets against this income from depreciation and interest expenses. So my pre-tax equivalent might be more like 6%. In this case, the investor is not terribly concerned about growth in the value of the property because any gains from price appreciation will not be realized for a long term and are of secondary importance. Of primary importance here is keeping good tenants, collecting 12 months’ worth of rent (and increasing that # by inflation), and maintaining stable property expenses. If I can earn the pre-tax equivalent of 6% a year without a lot of headaches, I should be happy with my investment.
Appreciation properties are basically the opposite of cash flow properties in every way. In an appreciation property, the investor puts as little down as possible and hopes to make money off of an increase in the value of the property. Let’s take a look at an example – I buy a single family home in a great location for $1,000,000. I put down 20% so my equity is $200,000. I finance the rest using an interest only loan that is locked in for 5 years and then resets annually. My plan is to sell this property in 2-3 years as I believe prices in this area will go up. Let’s assume I am correct and 2 years later, my home is worth $1,200,000. From a total return perspective based on price alone, I went from $1,000,000 to $1,200,000 in 2 years, a compound annual increase of 9.54%, not bad. But remember I only put $200,000 into the home. Two years later my debt is still $800,000 but my equity is now $400,000. That’s a return on equity of 100% in just 2 years! I am simplifying a bit because when I sell a home there are costs involved, but I am simply trying to illustrate the difference between a property that is being bought for cash flow purposes vs. one that is being bought for appreciation purposes.
Comparing these properties to traditional stock investments
If we were to compare these two properties to a more traditional investment in stocks, we would say the first one is a value purchase – its upside and downside are limited but it pays a good dividend so we want to hold it. The second is more like a growth stock, the value could increase or decrease rapidly and we are willing to hang on for the ride and see what happens.
The first one is a value purchase – its upside and downside are limited but it pays a good dividend so we want to hold it
At Summit our job is not to say all real estate investments are good or bad but rather to look at any current or potential investment a client might make and make sure it meets their overall objectives, is appropriate for them, is well understood by them, and offers a fair risk/return tradeoff.
Please note, Summit and its representatives are not licensed real estate agents. We can provide an opinion only or discuss how real estate may fit or compliment your overall investment portfolio. If you are a current real estate investor or are considering your first investment in this area, we are more than happy to see if we can help you make some smart decisions.