Investment Basics: Buy and Hold Money Makers

I have included an illustration today to show why real estate is such a good investment in the long term. Profits on real estate investments come in four forms: appreciation, amortization, cashflow, and taxation. For our purposes today we are going to address appreciation and amortization.

The Utah real estate market follows a stair-step appreciation curve over time on average. There are always local pockets of volatile prices but on the average real estate here appreciates quickly and then flattens out for a while before appreciating rapidly again.

Everyone knows how to make money with appreciation, thats why smart investors bought in 2004 and 2005. The lemming investors bought in late 2006 and 2007. Unfortunately for the lemming investors, they will have to wait to make a killing on appreciation. Hopefully they have amortized loans.

Here is our first chart for discussion:


This chart illustrates how people get rich in real estate. The late night gurus will tell you its about notes and quick profits. The true real estate investor knows that its all about time working on your side. In this example our property is a $200,000 3 Bed 2 Bath home. The red line in this chart represents your debt. This loan is amortized for 30-years and has a $0 balance at the end of its term. The black line is your property value. It follows a stair-step pattern modeled after our own market. 5 Years under 3% appreciation followed by 2 or 3 of 10%. Very similar to our own. The green line represents equity...or the difference between the black and red lines. Your main interest is the green line.

Lets pretend that this is your investment property. The first 5 years are going to be the toughest because there is little equity in the home. You have to sit on it just to make enough equity to sell it at a break even price. The reason this is the case is because you paid full price for this home and at the beginning of a down market. Expect it to take 3 or 4 years just to break even on a sale. Hopefully the rents compensate for the payments so you are sustaining yourself (this will be a separate issue we talk about later) At 7 years the market picks up again and you see some significant appreciation. You have made $100K in equity. Its been a hard slog but you are starting to see some returns. In just 8 more years you are at $200K in profits. Your rents have increased in the meantime so being a landlord seems a lot easier. After 30 years with appreciation and inflation working on your side, your meager home is now worth $700K free and clear. You keep almost all the rents! Now multiply this example by 5 or 6 homes. How nice does retirement look now?

Here is a preferred variation on the model that mitigates risk and provides greater returns and safer positions. This is the model that I find most appealing:




Rather than buying a $200K home at full price, lets pretend you bought a $240K home that was a distressed for $200K. Not only do you get the benefit of immediate $40K equity but you also could sell the place immediately if you had to. A much safer position to be in. Your payments on your mortgage are the same so your amortization pays off at the same rate but now you have a home that is worth more and will appreciate to larger dollar amounts than our previous example. Rather than being $700K. This home will be $850K in 30 years.

NOTE: These large dollar figures for 30 years from now may be hard to grasp but consider that today's prices are almost 3 times what they were in 1975. My parents paid $40K for their first home. That home today is worth around $150K.

Finally lets consider what interest only loans do to your situation:


This chart is a bit inaccurate because lenders will rarely give an interest only loan for more than 5-years. If you look at just the first 5 years the equity increase is insignificant. On top of that, at that time you are forced into a sale or refinance which will consume equity. You could risk making the payments when the ARM adjusts if you bought the property low enough but its risky. If you paid full price for the property you will be in hot water. For this reason, I don't believe ARMS are a good idea for long term investments. Only use an ARM if you buy the home 75% or less than market price. You can now understand why so many OWNER OCCUPANTS who went down this road are in real trouble.

If you have any questions or comments about this let me know.