Declining Returns in Real Estate (and How To Combat Them)

"Why would I invest in anything other than real estate?"

I get this question a lot, and there are some simple answers:

• You're buying yourself a job

• It can be tough to get your money out of it

• The transaction costs are high

• It will make your taxes more complicated

• Diversification - ever heard of it?

What I wanted to write about today is a little more complicated - real estate is a declining-return investment. What the h*ck does that mean?

I'll tell you, but FIRST (don't you hate it when we do this?), I want to make a note: I LOVE real estate as an investment, and it can provide great opportunities. But I ALWAYS recommend having investments outside of real estate, for all the reasons listed above.

A while ago, I wrote about the different pieces of returns in a real estate investment and how to calculate return on equity. If you want a deeper dive into what I'm talking about in this post, you can check out the previous stuff here.

So, what do I mean when I say that real estate is a declining-return investment?

Typically, your returns in early years of a given investment are going to be higher than your returns in later years. There are two main reasons for this:

1. You have more leverage in early years - less equity means a smaller denominator compared to your earnings.

2. Tax benefits (depreciation) leave you over time.

Example

CAUTION: What follows is a gross oversimplification to illustrate a point, and, as always, NONE of this is advice (because I don't know you, silly).

You decide to buy a rental property, and you happen to be in the 22% federal tax bracket.

You buy a 200k property with a 50k down payment and a 150k mortgage for 30 years at 6.5%.

Here are the deets:

19,200 annual rents (1,600/month)

11,377.20 annual mortgage payments (948.10/month)

3,000/year property tax

1,200/year insurance

3,500/year repairs

6,182/year depreciation

Some of these costs will stay flat over time (mortgage payments, depreciation), and others will increase (rent, taxes, insurance, repairs, and property value). For our purposes, we're going to assume that everything increases at 2%.

Year 1

Cash Flow: 123

Depreciation tax benefit: 1,360

Expected appreciation: 4,000

Mortgage paydown: 1,677

Total earnings: 7,659

Property value: 200,000

Beginning of year loan balance: 150,000

Equity: 50,000

Dwight's earnings (7,659) divided by his equity (50,000) shows a return of over 14% - pretty great! The main issue is - most of that return (the appreciation and the mortgage paydown) is locked up in the equity of the property; in fact, the appreciation of the property alone accounts for 8% of the total 14% - over HALF of the benefit. But you can only access it by taking a loan against it (and thus paying interest) or selling the property (in which case you'll owe taxes). Not. Ideal.

But you can't expect to get a 14% return every year. Let's look into the future - what's happening in year 20?

Year 20

Cash flow: 5,376

Depreciation tax benefit: 1,360

Expected appreciation: 5,827

Mortgage paydown: 5,715

Total earnings: 18,278

Property value: 291,362

Beginning of year loan balance: 89,707

Equity: 201,656

Now, most people see that cash flow increased from a measly 123 to 5,376 in those 20 years. In fact, they can expect a higher appreciation value and more mortgage paydown, too! But here's what they're missing - take all of that divided by the equity, and you'll see that the annual return is now down to about 9%. The main reason for the decrease is the lack of leverage from the mortgage - the 5,827 of appreciation is now less than 3% of the equity, while it was 8% early on.

Finally, let's take a look at year 31. Now the mortgage is paid off, and all of the depreciation has been taken.

Year 31

Cash flow: 20,831

Depreciation tax benefit: 0

Expected appreciation: 5,827

Mortgage paydown: 0

Total earnings: 28,076

Property value: 362,272

Beginning of year loan balance: 0

Equity: 362,272

At this point, your forward-looking return is still a quite okay 7.75%. But I've illustrated that point, so it's time to make another!

Example 2

What happens if costs rise faster than you expect - let's say at 3% annually instead of 2%?

And maybe you're not great at raising rents - maybe 1% annually instead of 2%?

And what if the value of your property grows at 1% annually instead of 2%?

Here's how it looks:

Year 1: 14%

Year 20: 5%

Year 31 and future: 3.7% (YUCK!)

It's pretty easy to imagine someone not raising their rents fast enough and slowly being overtaken by higher costs - ESPECIALLY since the largest expenses aren't even. Every few years, you'll have one LARGE expense (furnace, roof, pipe leak), so it's not necessarily easy to anticipate how your costs will rise over time.

You might be wondering if you should stay out of real estate altogether - I don't think that's the right answer.

In the first scenario, where rents, values, and costs all rise at 2%, even though the returns start at 14% and end up at 7.75%, the annual return over the 31 year period is just over 11%. I'll take it!

In the second scenario, even though returns end up in the gutter, the annualized return over the 31 years is about 7.75%. I'd be happy with this, but recognizing the time that goes into maintaining rental properties, I wouldn't be quite so happy about it.

Solutions

So - how do you benefit from the high returns real estate has to offer but avoid getting sucked into a low-return property?

There are a few options.

Evaluate Your Portfolio

Math sucks. Thankfully, you don't have to do the math. You can pay someone like me to do the analysis for you to make sure things are running smoothly or point out underperforming properties and strategize for how to improve your overall portfolio.

You can see how I work with people on my Services page. I also have an accounting practice if you need help with bookkeeping or taxes - more info on that at preeceaccounting.com.

Keep Accumulating

The main reason returns dwindle in later years is because of the loss of leverage. There's a simple solution to this if you're looking to grow your portfolio - just buy more real estate by using equity loans on your existing real estate.

You bought that first property for 200k with a loan of 150k - 75% loan to value (LTV). In a few years, when the value of the property is 220k and your loan balance is 130k, you'll be at 59% LTV. Taking an equity loan out for 35k to supplement the down payment for another property gets your LTV back up to 75% and allows you to use some of that equity to continue growing your wealth.

This basically allows you to reset into the early years of returns on the property you already owned and get another one going in those higher-earning early years as well!

Main downside here: leverage can be risky. It increases your potential returns AND your potential losses. Proceed with caution. Some people do deals with close to zero equity. They're either professionals who know what they're doing, have equity elsewhere in case sh*t hits the fan, or they're going to wind up in a world of hurt. Just because someone else is doing it doesn't mean you should, or even can.

Use 1031 Exchanges

In case you haven't heard, real estate is SUPER tax-efficient. One of the biggest benefits is that you can sell one property and roll the gains into another without paying taxes on the gain. This is called a 1031 exchange, and you should ABSOLUTELY discuss with a professional WELL before you plan on executing one, as there are all sorts of rules involved.

But let's use that example from up above. A few years into owning a property, it's now worth 220k, and you owe 130k on it. You don't want another property, but you do want to improve your returns and lever up, so you decide to execute a 1031 exchange.

Now, in order to defer ALL of the taxes, you have to wind up with AT LEAST as much debt as you started with (which shouldn't be an issue, since that's the goal), and you CANNOT take any cash out of the deal. So if we want to get back up to a 75% LTV with our 90k of equity, we're going to be looking for a property to buy for at least 360k. We'll have a down payment of 90k to match our equity and a loan for the other 270k.

What if you want to buy 500k property instead? Easy - just add cash to your down payment or see if the bank will lend you more.

Main downsides of this strategy:

1. 1031 exchanges are COMPLICATED. And complicated means you'll need to pay professionals to make sure it's done RIGHT. Because of this, they tend to make more sense for larger properties.

2. You have to find a new property to replace your old one with, and the timeframe is condensed because of 1031 exchange rules.

Now, if you're having a hard time finding a replacement property, you may be eligible use what's called a Delaware Statutory Trust (DST) as the replacement property in your 1031. DSTs are basically private real estate investment products built to receive funds from 1031 exchanges. They're pretty nice because you no longer have to manage anything about your property yourself - it's all taken care of for you.

Conclusion

At the end of the day, the main reason NOT to invest in real estate is the work you have to do to to run an efficient portfolio. Not just tenants and toilets, but the financial strategy that's necessary to ensure your portfolio is running smoothly.

That said, there's help out there. If you're looking for a firm that can help you:

• Evaluate your real estate portfolio with financial analysis

• Provide bookkeeping services so you don't have to categorize your own transactions

• Prepare your tax return(s)

• Offer other financial planning services OUTSIDE of real estate

  
  

Well then, you've found us!

Check out the rest of my preecefp.com site and hop over to preeceaccounting.com and book a meeting if you're interested in learning more.

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As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner in Eau Claire, Wisconsin, and I work virtually with people across the US. Check out my website to see what it's like to work with me and reach out if you have any questions.

If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.