On August 2, 2012 a tweet from Money Magazine came across my tweeter page @JustAskBen which read as follows:
1.3%: Annualized real return on real estate, 2000 to 2012.
I feel compelled to elaborate on this tweet since while Money’s assessment is likely statistically true in terms of an inflation-adjusted growth in equity over the stated period, to consider real estate returns in this fashion is to miss the forest for the trees. Let me explain.
Let’s say we bought a property in the year 2000 for $100,000. An average annual appreciation of 1.3% would equal to an increase in equity of $1,300 per year, which is certainly not anything to write home about. However, at that time $100,000 bought a very nice duplex in my neck of the woods, capable of easily generating $400 of month cash flow when leveraged 100%. This is $4,800 of annual cash flow which combined with the appreciation in equity brings the ROI to $1,300 + $4,800 = $6,100.
But there’s more. Throughout the same 12 years, the tenants will have paid down about $20,000 of the mortgage, figuring an $100,000 loan at 6% amortized over 30 years. This is free money as far as I can tell. The owner is not making those payments which are buying his/her equity in this building – the tenants are! Thus, we can add about $1,650 of freed-up equity annually to our ROI bringing it to $7,750.
But we are still not done because on a property like this we can likely look forward to about $3,000 of annual depreciation, $6,000 of interest write-off if fully financed at 6%, and a bunch of other write-offs which at a 15% income tax brocket could add up to savings of around $1,500 on April 15th. That’s real money that stays in the pocket of the owner which and thus need to be considered as part of ROI, bring it to $9,250 annually.
So, the real bottom line benefit of ownership of this property is not mere $1,300 (1.3%) but potentially $9,250 (9.25%) annually. Moreover, in this example the entire $100,000 needed to acquire this property is borrowed and thus it can be said that we invested $0 of our own money to generate $9,250 of annualized return; $111,000 over the course of 12 years of guaranteed return! How would you measure this ROI? Infinity? And this is a very conservative example…
Yes, I concur that in terms of equity real estate went nowhere from 2000 to 2012. However, it is shortsighted to focus solely on this fact; anyone who does is missing the forest for the trees. Over the long term values will absolutely go up – the inflation, which is a necessary by-product of our monetary system will take care of that. But, this is not necessarily how we measure investment returns in real estate.
Conventional wisdom often leads us astray because it focuses on that which is obvious. The trick is to learn to see that which is not so apparent, to which end I am reminded of a quote by the great Helen Keller:
“The only thing worse than being blind is having sight but no vision.”
© Copyright 2012 Ben Leybovich and Just Ask Ben Why. All Rights Reserved.