How to look at real estate ROI

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hcj
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How to look at real estate ROI

Post by hcj » Sat Oct 04, 2014 2:30 am

I would like to get some opinions on this. This is what I was taught and it makes sense to me, but please poke holes in it.

The idea is that you should calculate real estate return (appreciation, realized on sale of the property) pretty much the same way you would calculate return on any other investment. (I'm asking because this seems contrary to the ideas you and others described about return on equity for real estate. But most likely I just am not understanding. So thank you in advance to anyone who is willing to take the time to explain this to me.)

Anyway. It goes something like this:
1) Your down payment is the money you are investing - say 20% of 372k = 75k
2) Your mortgage payments are the money you would have spent paying rent anyway. Plus, bonus! You get a tax break.
3) Let's say you sell it for 495k
4) After commissions and paying back the mortgage loan principal, you net 170k
5) Subtract other costs of ownership over, say, two years: 4k property tax per year and 2k in maintenance/repairs. 10k total.
6) So ROI is 100% -- 85k (75k down payment + 10k ownership costs) --> 170k.

I think most of all I am trying to parse this out:
To grow income, there is a relationship between the income statement and balance sheet. At a highly simplified level this is called return on equity. Many in here are reacting to your very poor return on equity. This would suggest 'as a real estate investor that you are a very poor one.' The investment value of your property is reduced to its potential to appreciate only.
Is it bad, or why is it bad, to have the investment value of your property reduced to its potential to appreciate. Isn't that what a stock does too? It's all paper gains until you sell it?
Last edited by hcj on Sat Oct 04, 2014 2:57 pm, edited 2 times in total.

ResearchMed
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Re: Pizzasteve come in: my real estate question

Post by ResearchMed » Sat Oct 04, 2014 8:12 am

hcj wrote:I would like to get some opinions on this. This is what I was taught and it makes sense to me, but please poke holes in it.

The idea is that you should calculate real estate return (appreciation, realized on sale of the property) pretty much the same way you would calculate return on any other investment. (I'm asking because this seems contrary to the ideas you and others described about return on equity for real estate. But most likely I just am not understanding. So thank you in advance to anyone who is willing to take the time to explain this to me.)

Anyway. It goes something like this:
1) Your down payment is the money you are investing - say 20% of 372k = 75k
2) Your mortgage payments are the money you would have spent paying rent anyway. Plus, bonus! You get a tax break.
3) Let's say you sell it for 495k
4) After commissions and paying back the mortgage loan principal, you net 170k
5) Subtract other costs of ownership over, say, two years: 4k property tax per year and 2k in maintenance/repairs. 10k total.
6) So ROI is 100% -- 85k (75k down payment + 10k ownership costs) --> 170k.

I think most of all I am trying to parse this out:
To grow income, there is a relationship between the income statement and balance sheet. At a highly simplified level this is called return on equity. Many in here are reacting to your very poor return on equity. This would suggest 'as a real estate investor that you are a very poor one.' The investment value of your property is reduced to its potential to appreciate only.
Is it bad, or why is it bad, to have the investment value of your property reduced to its potential to appreciate. Isn't that what a stock does too? It's all paper gains until you sell it?
Not sure why you are asking only one BH member to respond via the title, but that's not what this is about. (My meaning in that is you may in fact get fewer eyeballs reading your questions. Or maybe you'll get more, wondering why you are calling out one of so many helpful souls here.)

Where in the world are you sure to get such a huge appreciation in what seems to be 2 years (based upon the ownership costs timeframe)?
That's a huge amount/percentage, even "forgetting" that the selling costs are already removed.

Your cost of ownership in terms of maintenance might work over two years if you don't need any *real* maintenance (new furnace, roof, A/C, appliances, or assorted repairs) and if you postpone most ongoing things and don't save for them (repainting?).
But that's not a reasonable amount to be setting aside in the longer term.

And you haven't accounted for what that down payment "could have been earning" in the meantime if not tied up in the real estate.
Granted, now is not a time when there is much to gain from "safe" income such as savings accounts, but some CD's are creeping back up.
Longer term, bond funds might be a good comparison, or even equities. Or a REIT, if you want similar sector.

Then you have moving expenses (and decorating, painting, fixing problems that are discovered) for the next home.
And usually some overlap on the two mortgages, or else you are moving everything instantly at midnight - and it's not always easy to find a buyer who wants to close exactly when you do, so there could be several months of overlap, especially if the home doesn't sell as fast as you had hoped.
If you move to a rental in between to avoid an extended problem like that, then you have two moving costs, plus uprooting a family twice.

You need to do some reading about all of this: real estate, investing, finance in general.
Perhaps some other BH's could recommend a few good starting books, so that you can begin getting a grasp on the big pictures, and not see each little piecemeal part in isolation. (Like forgetting you could have invested the down payment elsewhere.)

Mostly, that 2-year ROI is almost definitely way too high, which is why your example seems so very appealing.
An occasional investor finding a gem of a fixer-upper might stumble across something like that, but not often, as other investors would probably see it too, and the bidding war begins...

Edit to add: And what if the property LOST VALUE instead of appreciating?
That is an all too real possibility, as all too many people know first hand.

RM
This signature is a placebo. You are in the control group.

ResearchMed
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Re: Pizzasteve come in: my real estate question

Post by ResearchMed » Sat Oct 04, 2014 8:43 am

As for your final comment,

"Is it bad, or why is it bad, to have the investment value of your property reduced to its potential to appreciate. Isn't that what a stock does too? It's all paper gains until you sell it?

Think about dividend stocks, or the yield on bonds, or even the yield on CD's (historically higher than most are now).

There are lots of debates about whether investing in dividend-paying stocks is better than non-dividend-paying (growth potential only, rather than throwing off dividends).

However, there are many retirees who LIVE ON DIVIDENDS ALONE.
Perhaps they want to leave the stocks to their children/grandchildren.
Or use the stock value for long term care if needed.

Again, you should spend some time on more general reading.
You've been exceptionally privileged thus far, and haven't needed to deal with many of these issues, but suffice it to say that it is NOT "that easy" (and certainly NOT guaranteed!], and that's safe to say about just about any "approach".

You are also fortunate to be very intelligent and open to getting more information and insight, and that will probably (hopefully!) save you and your family a world of hurt in the future (as the trust funds deplete, etc.).
But spend some serious time reading about "finance more generally" for some important background.

Then, Bogleheads IS certainly a wonderful and valuable resource for questions!
But it can't substitute for background reading.

RM
This signature is a placebo. You are in the control group.

wilked
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Re: Pizzasteve come in: my real estate question

Post by wilked » Sat Oct 04, 2014 9:12 am

hcj wrote: 1) Your down payment is the money you are investing - say 20% of 372k = 75k
Off to a good start
hcj wrote: 2) Your mortgage payments are the money you would have spent paying rent anyway. Plus, bonus! You get a tax break.
uh oh, buried assumption that PITI = equivalent rent. I just bought a house, and PITI is ~50% greater than our previous rent
hcj wrote: 3) Let's say you sell it for 495k
And we hit our first landmine. Why not run the calc a second time and assume you sell it for 250k? It has as much basis in reality as 495k
hcj wrote: 4) After commissions and paying back the mortgage loan principal, you net 170k
5) Subtract other costs of ownership over, say, two years: 4k property tax per year and 2k in maintenance/repairs. 10k total.
Need to check the math on #5. Are you assuming 20 months of ownership ($6*20/12 = 10)?

I am not sure if you have taken a finance class but your math and assumptions are rife with issues, the biggest of which is assuming 30% market uptick in less than 2 years.

Pizzasteve510
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Re: Pizzasteve come in: my real estate question

Post by Pizzasteve510 » Sat Oct 04, 2014 10:02 am

First, thanks for the compliment, but no need to add my name to the post title. I am far for the sharpest tool in this shed.

That said, a few quick comments follow, as I have limited time this morning. I will pop back in later.

An ideal "personal home" real estate investment is one that follows the outline you describe above. These scenarios always look good if three factors work in your favor:

1. Assumption of appreciation
2. Leverage
3. Rents increase above mortgage/ownership costs

If these three factors work in your favor, you have a great result. They can make up for many negatives, including the ones already posted, which broadly categorize as transaction costs and maintenance costs (which tend to be high in residential real estate).

However, Your real estate assets will be very poor ones if #1 and #2 do not work in your favor. #3 is a factor, but generally only if #1 is happening, so let's consider them the same.

So, someone living in the SF area of Northern California over the last two decades might think increasing rents and home values is a fact of life, however history suggests that this does not always happen for a specific investment period. You are especially at risk for a short time horizon.

So the short answer is this. You describe an 'I win' scenario. 'I win' scenarios do not always occur.

Illustration (perhaps a hasty poor one)
I will describe a few others. Scenario 1: You sink all your assets into your home and the price does not go up. Your costs equal rent costs while living there, or you rented it out at a break even. Assuming your costs roughly match what they would have been under a rental, after paying a broker a commission, maintenance, insurance, etc. Then you have earned nothing on your assets. It is as if you put your money into a savings account earning 0%. Return on assets is 0 - you saved, which is good. Passive income is 0. Scenario 2: you sink all your assets into your home and it drops in value. In this case, leverage suddenly works against you. Say it drops 20% in value and you borrowed 80% at a interest only loan. In this case you still owe the 80%, but have lost your entire 20% deposit. You have lost 100% of your investment due to your 5x leverage! So in this case you blew all your savings on a bad investment. Passive income is -whatever you put into the house divided by year. You added expense to your consumption with nothing to show for it. Both if these scenarios are possible. If in these scenarios you were a renter, who invested extra cash in a CD earning income you would be far ahead of your home owning clone. You might search out the many buy vs rent threads.

A bit more....
Lets look at the factor of appreciation. Why do home values increase? Studies I have read suggest that housing prices are driven by many factors, but that two of the most important ones are the following:

a) construction costs (including land, infrastructure, materials, amenities); and
b) personal income (demand for housing in terms of what someone is willing to pay to live in an area).

Item a is pretty easy to think about. Inflation or scarcity of land/available labor/infrastructure can drive up construction costs, hence you have to pay more to build a new home, hence developers will need to charge more. There are limits to this based on factor b, but if incomes rise then everyone makes money. However, if incomes are not high enough, no one can afford to buy in an area with unlimited cost growth. The opposite can occur. Study Atlanta today for a good example. Literally people who bought cute 4BR homes for 15k have LOST MONEY. Due to high tax assessments, job losses destroying communities, and govt corruption investors are literally abandoning homes to squatters.

So one who grew up in a community with unprecedented income increases, high construction costs and scarce labor/land availability might have the false impression that because houses always go up in their area that prices always behave that way. It is wrong that houses only go up. It is also wrong that ownership costs will always track to a rate that they increase below rental costs (wrong). In some part of downtown Atlanta you can stay in a home for free in some areas, if you promise to keep squatters out. An owner would be happy if you did. These are homes within a few miles of where the Braves play.

By example, and I think this is where you may have formed false impressions, lets compare two markets, Palo Alto, CA and Dallas, Texas. Both areas are wonderful communities to live in. I can say from experience that the feeling you might have living near Stanford is not all that different from living near Southern Methodist University. Quiet suburbs near an excellent university. Both areas have had periods of growth and high appreciation. Anyone who has lived in these areas and held long enough has done fairly well with real estate, at least not lost their shirt.

However, if I had the power to show price charts, you would see that Palo Alto looks like the Japanese stock market before the bubble burst, while Dallas looks a lot more up and down. Also, because Dallas is flat, with good highways, you can build outward almost without constraint. In the 90s I bought a wonderful 5BR home 15 minutes north for $180k. It was ten years old and was built for $270k by the original owner. 5 years later it sold for 220k. We did fine, the original owner lost their shirt. It is now worth about 320k today.

In Palo Alto, Sunnyvale, SF, etc., that same purchase would have been a rocket ship to wealth creation. I remember modest homes in that area in the 70s being quite attainable that are worth millions now. Anyone in that area would think they are a real estate genius, but the factors of scarce resources combined with historically unprecedented high income job creation from high tech, the values have gone through the roof.

So, in conclusion. It seems that for your circumstances you want to live in the area where you are. The lowest perceived cost of 'living ' is to pay your mortgage on a high value home. However, if your goal is really wealth creation, you would live elsewhere for much less, and then rent your home out to someone who could pay you thousands in rent. However, your high income jobs are linked to the need to be in that area, so you consume that economic rent on your assets yourself. Hence you are high income, high expense, large assets, but very low return on passive assets. IF the home continues to increase in value and IF you can sustain your income (these are highly correlated by the way both for upside and downside scenarios) then the factor of leverage will either work for you, against you or be neutral. It all depends.

From a consumption standpoint, realize that living in your home has a high opportunity cost for rent you could be investing or spending, if your cost of living was more in line with average. Also realize that your strategy of placing your net worth in the hands of the local real estate markets is statistically much more risky. Your future is more at the mercy of market real estate forces which no one can fully predict.

[edit]. One other way to look at it. Your biggest financial investment is in your career. That produces the most income, as a cost of your labor. Often jobs are linked to industries linked to a community. If your job fails due to weakness in your industry, it is possible housing prices also drop in the same area. That is why index funds are favored. You spread risk over the whole market. In real estate that type of diversity is most often found in a REIT. Concentration risk is what this is sometimes called. So the ski home might be a better investment in terms if that risk, as it's value depends on wealthy people from a larger area.

[edit 2]. It strikes me as handy to explain in very summary terms why the Dallas house was so cheap when bought. In the early 90s the oil and gas markets had some horrible results. Much of the labor income in communities like Denver, Houston, Dallas and Oklahoma City depended on this industry. These markets also had very efficient housing building industries cranking out tons of supply of new homes. As a result of the incomes drying up, and the many houses that needed to be sold (by folks spending close to earnings and by developers) pressures on prices were intense. Few new buyers, many sellers and guess what, the market tanked. Homes suddenly were available 30-50% cheaper. Eventually, the developers slowed down, the local economy diversified, and because of solid fundamentals like infrastructure investments in a world class airport, low taxes and a well educated work force, cities like Dallas recovered. Now a leader in telecommunications, consumer products, etc., plus a recovered energy industry makes Dallas real estate viable. That said, the market may never have scarcity other than in a few elite areas. Dead shopping malls exist side by side with Gucci shops in palatial hip areas to shop. Some cities like OKC still struggle to recover. Use zillow and you will see former homes of oil industry executives for sale at amazingly affordable prices.
Last edited by Pizzasteve510 on Sat Oct 04, 2014 1:51 pm, edited 3 times in total.

hcj
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Re: Pizzasteve and others: my real estate question

Post by hcj » Sat Oct 04, 2014 11:24 am

Thanks RM, wilked and Pizzasteve, for my weekend reading :)

@RM: I changed the title, thanks for pointing that out

I would really like some general finance book recommendations, if anyone has some they like or think appropriate for me. I've tried reading them in the past and my eyes glazed over. But I'm more motivated now.

I'll also just state the question underlying this real estate pondering: I'm trying to evaluate our investment options once we sell the house and have a larger pot of money to manage than we have ever had before. So far I see it as:
1) invest in stocks/bonds/??? mix
2) buy a rental property
3) combination of both

And while I knew (the primary?) reason people did not go into real estate is because of the hassle, illiquidity, and higher risk -- I thank Pizzasteve for laying that out with real life examples.
However, there are many retirees who LIVE ON DIVIDENDS ALONE.
I did not know this was possible. Wow.

BTW, my example was with real numbers and real timing. It was a crazy, crazy time (but I keep seeing crazier times yet, so that's why I get hung up on this, I think). I actually missed out on the next $600k of appreciation on that home--within a space of 4-5 years. But (and this is argument for the hassle and how it has to work into your real life) there was no way I wasn't going to sell, because I had bought it with a partner and the relationship didn't work out--either he had to buy me out or I had to buy him out, and he wanted to stay more than I did.

Pizzasteve510
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Re: Pizzasteve and others: my real estate question

Post by Pizzasteve510 » Sat Oct 04, 2014 1:36 pm

I don't have any good book recommendations, but I am sure others do.

If you like risk, RE can be rewarding, but as we mentioned above, succeeding in real estate is either luck or full of tricky bits to master. Frankly, the successful RE guys I meet are generally either very fortunate, extremely innovative (rare) or are cut throat, manipulative people who pressure everyone around them for results and are not fun to be around.

...[edit...removed a personal example and added to response above...] All this type of stuff happens and solving them leaves less time for skiing. Stocks and bonds are more popular I think largely because they are relatively low effort.

clevername
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Re: Pizzasteve and others: my real estate question

Post by clevername » Sat Oct 04, 2014 2:21 pm

I guess it would look something like this:

-----------

Proceeds from sale of house
Less: Selling expenses (realtor, lawyer, closing costs)
Less: Purchasing price
Equals gross profit (loss) from sale of house

Less:
interest
real estate taxes
insurance
maintenance
opportunity cost from down payment

Plus:
Equivalent cost of rent over period
Marginal tax advantage of home ownership vs renting (eg: excess of itemized deductions over standard deduction)

Equals: total gain/loss from home ownership before federal/state income taxes

----------

Re: taxes. People always overestimate the tax value of deducting mortgage interest and real estate taxes. To get the MARGINAL tax advantage of home ownership vs non-ownership you have to find the difference between what you deduct as a home owner vs what you would deduct as a renter. So if you are an MFJ couple and the total of your mortgage interest, RE taxes, state/sales tax, etc is 12,000, and your standard deduction is 12,200, then your tax benefit from home ownership is zero because you would take the standard deduction either way.

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ray.james
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Re: Pizzasteve and others: my real estate question

Post by ray.james » Sat Oct 04, 2014 2:41 pm

hcj wrote: I'll also just state the question underlying this real estate pondering: I'm trying to evaluate our investment options once we sell the house and have a larger pot of money to manage than we have ever had before. So far I see it as:
1) invest in stocks/bonds/??? mix
2) buy a rental property
3) combination of both
From the other thread, you are risk averse and are not comfortable with stock market. So, you can choose a good portion into fixed income, like bonds, cd's ladders, ibonds with a minor portion in stocks. If real estate is something you are comfortable in both ways - as a vehicle to saving money and dealing with management of the rentals, then it is not a bad deal. Just be aware like stocks, real estate has its own down turns & risks.

Look at the images on these pages:
https://personal.vanguard.com/us/insigh ... llocations

You can see the average return and also worst year. I would recommend a 40 stock/60 bond to start with and after the first 5/10% market decline/ a future recession you can decide to raise more stock based on emotions. The asset allocation would still apply even if you go for your option C.
When in doubt, http://www.bogleheads.org/forum/viewtopic.php?f=1&t=79939

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interplanetjanet
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Re: Pizzasteve and others: my real estate question

Post by interplanetjanet » Sat Oct 04, 2014 10:53 pm

clevername wrote:Re: taxes. People always overestimate the tax value of deducting mortgage interest and real estate taxes. To get the MARGINAL tax advantage of home ownership vs non-ownership you have to find the difference between what you deduct as a home owner vs what you would deduct as a renter. So if you are an MFJ couple and the total of your mortgage interest, RE taxes, state/sales tax, etc is 12,000, and your standard deduction is 12,200, then your tax benefit from home ownership is zero because you would take the standard deduction either way.
It's also important to really work out your tax situation. If you are in AMT territory as a renter (not hard to do as a family with children in California) then your mortgage interest is deductible from the first dollar, while your property taxes give you no tax benefit at all. Using tax software and plugging in different numbers to see what happens to your tax can be a valuable exercise.

hcj
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Re: Pizzasteve and others: my real estate question

Post by hcj » Sun Oct 05, 2014 9:27 am

@RM and others who brought up the opportunity cost - what the down payment would have earned in a CD or similar if not plunked down into the property:

If I add in the layer that I am evaluating the real estate as an investment option vs other investment options, do we still have to account for the opportunity cost? Asking because the opportunity cost part doesn't make sense to me unless you are putting the money into something that has no possibility of generating a return, i.e. just spending it. Example: if I had invested the money in the stock market, we would not subtract the opportunity cost when we calculate the stock market return, right? I'm pressure-testing why real estate investment should be calculated differently from other forms of investment. (Please plug in other numbers, including negative ones, if that makes more sense to you. I am honestly just trying to get at *how* to evaluate the return, positive or negative.)

Which segues nicely into this:
clevername wrote:I guess it would look something like this:

-----------

Proceeds from sale of house
Less: Selling expenses (realtor, lawyer, closing costs)
Less: Purchasing price
Equals gross profit (loss) from sale of house
Again, pressure-testing. Why would we calculate proceeds from purchase price and not the amount of the down payment + paying back the balance of the loan? You did not actually shell out the purchase price, unless you purchased all in cash.
clevername wrote: Less:
interest
real estate taxes
insurance
maintenance
opportunity cost from down payment

Plus:
Equivalent cost of rent over period
Marginal tax advantage of home ownership vs renting (eg: excess of itemized deductions over standard deduction)

Equals: total gain/loss from home ownership before federal/state income taxes
Good call out on the insurance cost, I forgot to include that in my example numbers. And I like the "equivalent cost of rent" instead of just looking at it as "I would have had to pay rent anyway".

hcj
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Re: How to look at real estate ROI

Post by hcj » Sun Oct 05, 2014 10:04 am

@pizzasteve: I really appreciated your thoughts/analysis and examples. And that reminds me that in my own personal circle/extended family (aunts/uncles/etc), I can think of a few who lost their shirts in real estate. It is a good reminder that I am not a real estate genius, I just lived through an era in an area that might make me think I am one, and I might not be so lucky on the next venture out.

We briefly toyed with the idea of renting out our current home (instead of selling), and part of me is still kicking around whether hanging onto it is a safer strategy for us than putting the resulting equity into the market. (I have managed to lose money in bonds also... I guess despite the getting lucky aspect of real estate, I do feel like I at least know it better.) We bought the house at the last low, and based on scarcity and location I am 95% confident that we will make out OK holding onto it. I know that I have to have enough reserves to ride out the lows and not be forced to sell at a bad time. But, the farther out we get from when we bought it (and I'm projecting way out now, as in decades), the less likely that any low will go as low as when we bought and result in losing equity.

Leaning more towards selling though, as it's not a good rental for us. Too much maintenance and not a lot of rent compared to selling and then buying some smaller units. Which I would not do immediately, as the market has once again taken off (here-here, not vacation-home-here). So I guess in the end we will still need to put it into the market for a time.

hcj
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Re: Pizzasteve and others: my real estate question

Post by hcj » Sun Oct 05, 2014 10:05 am

ray.james wrote: From the other thread, you are risk averse and are not comfortable with stock market. So, you can choose a good portion into fixed income, like bonds, cd's ladders, ibonds with a minor portion in stocks. If real estate is something you are comfortable in both ways - as a vehicle to saving money and dealing with management of the rentals, then it is not a bad deal. Just be aware like stocks, real estate has its own down turns & risks.

Look at the images on these pages:
https://personal.vanguard.com/us/insigh ... llocations

You can see the average return and also worst year. I would recommend a 40 stock/60 bond to start with and after the first 5/10% market decline/ a future recession you can decide to raise more stock based on emotions. The asset allocation would still apply even if you go for your option C.
Thanks very much -- this is very helpful.

avalpert
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Re: Pizzasteve and others: my real estate question

Post by avalpert » Sun Oct 05, 2014 10:51 am

hcj wrote:
clevername wrote:I guess it would look something like this:

-----------

Proceeds from sale of house
Less: Selling expenses (realtor, lawyer, closing costs)
Less: Purchasing price
Equals gross profit (loss) from sale of house
Again, pressure-testing. Why would we calculate proceeds from purchase price and not the amount of the down payment + paying back the balance of the loan? You did not actually shell out the purchase price, unless you purchased all in cash.
The down payment + paying back the balance of the loan is the purchase price, the only difference between what you are saying and what clevername said is on which side of the ledger you include principle payments but the outcome is the same either way.

However, you should be clear that you did shell out the purchase price, you just happened to take out a loan to raise the capital to do so.
"@RM and others who brought up the opportunity cost - what the down payment would have earned in a CD or similar if not plunked down into the property:

If I add in the layer that I am evaluating the real estate as an investment option vs other investment options, do we still have to account for the opportunity cost? Asking because the opportunity cost part doesn't make sense to me unless you are putting the money into something that has no possibility of generating a return, i.e. just spending it. Example: if I had invested the money in the stock market, we would not subtract the opportunity cost when we calculate the stock market return, right? I'm pressure-testing why real estate investment should be calculated differently from other forms of investment. (Please plug in other numbers, including negative ones, if that makes more sense to you. I am honestly just trying to get at *how* to evaluate the return, positive or negative.)"
You don't need to include opportunity costs if you are going to compare the rate of return directly to other investments - it has the same effect.

But back to your OP, there are two big things in your evaluation sequence that can really lead you astray. First is #2, your mortgage payment and the rent you would pay for alternative living should in no way be compared to one another - this is a recipe for bad mistake. Any financing costs you incur in buying are one component of the total cost of ownership that can be compared to rent but looking at the mortgage payment number alone irrelevant and a distraction.

Second, what you show through your high ROI in the example you gave is the power of investing on leverage - you need to look at the other side of that coin and the impact leverage has on a loss. Sure this may have been a real experience in say 2003, but look at what could have happened if you bought on leverage in 2007 and sold in 2009. And of course if you are okay with the added risks of leverage you can use it to invest in equities just like you can real estate.
Last edited by avalpert on Tue Oct 07, 2014 8:02 am, edited 1 time in total.

avalpert
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Re: How to look at real estate ROI

Post by avalpert » Sun Oct 05, 2014 10:54 am

hcj wrote: We bought the house at the last low, and based on scarcity and location I am 95% confident that we will make out OK holding onto it. I know that I have to have enough reserves to ride out the lows and not be forced to sell at a bad time. But, the farther out we get from when we bought it (and I'm projecting way out now, as in decades), the less likely that any low will go as low as when we bought and result in losing equity.
What price you bought it at is irrelevant to decision going forward - this is a great example of anchoring bias at work. Ignore whether you are selling at a gain or loss (save for potential tax implications of a gain which you can think of as a cost and possible inability to repay loans on a loss) the only question is given what you could get for it today, does it make sense to hold on to it or sell it.

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Re: How to look at real estate ROI

Post by hcj » Sun Oct 05, 2014 11:18 am

Btw: I am becoming less risk averse just playing with firecalc. Hard to argue with 100+ years of history.

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Re: How to look at real estate ROI

Post by hcj » Sun Oct 05, 2014 11:24 am

Thank you avalpert. I have to come back and read that a few more times with some time in between to think about it. I sincerely want to know where the fallacies in my thinking are so I can work them out of my system. I need to hear these points and arguments. So thank you.

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Re: How to look at real estate ROI

Post by travellight » Sun Oct 05, 2014 6:18 pm

I did not see an answer to your question this morning about opportunity cost, OP. I am also curious about that being brought up with RE but not with stocks.

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Re: Pizzasteve and others: my real estate question

Post by Meg77 » Mon Oct 06, 2014 3:24 pm

hcj wrote: I'll also just state the question underlying this real estate pondering: I'm trying to evaluate our investment options once we sell the house and have a larger pot of money to manage than we have ever had before. So far I see it as:
1) invest in stocks/bonds/??? mix
2) buy a rental property
3) combination of both
There are a few more options, including starting/buying a business, purchasing or betting on commodities, investing in angel or private equity funds, and trading collectibles. But in general you are right: stocks, bonds, cash and real estate are the four most accessible and typical asset classes. If you're an expert on one asset class and don't mind putting all your eggs in one basket (which would mean you are not very risk-averse), then you can be forgiven for betting your retirement on one asset class. Many people invest solely in real estate or in their own business and retire just fine. Others simply earn a salary and invest a portion of their earnings into the stock market via a 401k for most of their lives and amass plenty of money to fund a comfortable retirement. As far as opportunity cost goes, hindsight is 20/20. You never know what will have performed better until after the fact - that's why diversification is so important.

In my case, I decided to diversify and go with your option #3. I started out in my first job contributing no less than 15% of my gross income to retirement accounts. But on the off chance the stock market crashes just before or after I retire, I wanted to have another "bucket" to rely on. So I started purchasing rental properties with any windfalls or additional savings I managed to accumulate. My first home was a condo I selected 6 years ago with an eye for making it a rental down the road. I just got married and converted it to a rental as planned; my husband and I bought a town home which we also plan to rent out one day when/if we have kids and move to the burbs. So if Great Depression II or World War III strikes when I'm 67, at least (hopefully) my real estate will throw off some income.

In short - just do both! Investing in liquid securities has many advantages, not least of which (especially at your income level) are the tax shelters that you can get via 401ks, IRAs and HSAs. It's easy, it's automatic, you dollar cost into the market every 2 weeks without having to worry about timing or anything else. So DO THAT. But you have enough money to do both - and you are comfortable with real estate. That's great too. It's good for forced savings and comes with some tax breaks of its own.

I will say that type of property does matter. In general it's hard to consider homesteads a great investment since they often don't cash flow as rentals, maintenance can be very high, and transactions costs to buy and sell (and to cash out equity) are high. If you've been lucky in your area then that's great; but ultimately as far as retirement goes you'll be better off buying a small apartment building or series of duplexes or single family homes closer to the median home price in your area for income. Appreciation is great but you can't eat equity - you'll need cash flow in retirement.
"An investment in knowledge pays the best interest." - Benjamin Franklin

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Re: How to look at real estate ROI

Post by swaption » Mon Oct 06, 2014 3:54 pm

hcj wrote:I would like to get some opinions on this. This is what I was taught and it makes sense to me, but please poke holes in it.

The idea is that you should calculate real estate return (appreciation, realized on sale of the property) pretty much the same way you would calculate return on any other investment. (I'm asking because this seems contrary to the ideas you and others described about return on equity for real estate. But most likely I just am not understanding. So thank you in advance to anyone who is willing to take the time to explain this to me.)

Anyway. It goes something like this:
1) Your down payment is the money you are investing - say 20% of 372k = 75k
2) Your mortgage payments are the money you would have spent paying rent anyway. Plus, bonus! You get a tax break.
3) Let's say you sell it for 495k
4) After commissions and paying back the mortgage loan principal, you net 170k
5) Subtract other costs of ownership over, say, two years: 4k property tax per year and 2k in maintenance/repairs. 10k total.
6) So ROI is 100% -- 85k (75k down payment + 10k ownership costs) --> 170k.

I think most of all I am trying to parse this out:
To grow income, there is a relationship between the income statement and balance sheet. At a highly simplified level this is called return on equity. Many in here are reacting to your very poor return on equity. This would suggest 'as a real estate investor that you are a very poor one.' The investment value of your property is reduced to its potential to appreciate only.
Is it bad, or why is it bad, to have the investment value of your property reduced to its potential to appreciate. Isn't that what a stock does too? It's all paper gains until you sell it?
FWIW, I don't see anything horribly wrong with your analysis above. One can quibble about the relative lelvel of rent vs. mortgage payments, but in many cases they can be in the same area. And of course the very positive results stemming from your assumptions work just fine for demonstration purposes only. But we are not talking about rocket science here. Things get a little more complicated if there is no mortgage. You need to include in your cash flow what you would otherwise may have paid on a mortgage or rent, and then from a budget persepctive, you actually need to invest that money every month. I'm not sure i get where the opportunity cost is relevant. At the end of the day, if you calculate what your actual return (or in advance if it is expected return), the opportunity cost is just what is used as a metric against which the return is measured. I'm not sure it necessarily has to enter the equations.

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Re: How to look at real estate ROI

Post by HomerJ » Thu Oct 09, 2014 9:30 pm

Did your parents make their money buying and selling houses quickly for profit?

Or did they build up rental properties slowly over time?

From the other thread, you have more than $1 million tied up in the house you live in... That house is not bringing you any income, instead it costs a lot to maintain such a nice home.

If you had $1 million in 3-5 different rental properties all full of renters sending you checks every month... now that I would consider an investment...

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Re: How to look at real estate ROI

Post by hcj » Thu Oct 09, 2014 11:06 pm

Thank you so much for the different viewpoints and suggestions. All very good points!

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