My response to real estate as an asset class has always been “meh.” Perhaps it’s because it’s too predictable, not as much fun as equities, or maybe just because it seems old man-ish. You know – grey hair, blue pin stripe suit, and a gold watch at a country club type old man.
But recently, I’m having a bit of a change of heart.
Lingering Conflicts with Real Estate
My biggest complaint with real estate is that the market is slllloooooow. That is to say it is very difficult to find a property generating 10% returns that can be sold a few months or even years later at a price that implies a 6% return.
This happens all the time in the stock market. This is pretty much my investing strategy in a nutshell – buy a company at a high discount rate or free cash flow yield, sell when the market implies a low discount rate or free cash flow yield. In most cases, I’m looking for companies that can reliably generate free cash equal to three times the current rate for long-dated government securities. So, right now with 30-year Treasuries at 4%, I want companies that have a free cash flow of at least 12%.
In an ideal world, the market will come to its senses and price a stock at a free cash flow yield of 8% from 12%. My investment would then rise in value by 50% and I’d move on to the next.
Mo’ Cash Flow in Real Estate
Here’s an example of a deal available in my area. An all-brick duplex built in the 1960s is up for sale for $85,000. The house is in a very good area – a place where I would not hesitate to live for a minute. Both sides of the home are currently occupied, and renting for $550 each, or $1100 per month.
That implies a return of 15.5% per year. Granted, there are plenty of expenses, but assuming even one-third of the rent is dedicated to maintaining the property, the return is still an easy 10% per year. These are well built homes, so I don’t think there’s any real major work to be done. Also, the price and yield is consistent with other duplexes in the area, so this isn’t an odd-ball cheap-o property.
This is the kind of return that is very, very hard to find in large caps. I can find this kind of free cash flows in companies worth $200 million to $5 billion with regularity. However, the leverage is what really changes the whole ballgame.
Assuming 20% down, the mortgage principal is only $68,000. The monthly payment works out to $328 financed for 30 years at a 5% rate. Assuming crazy upfront costs of $3,000, we arrive at total initial out of pocket investment of $20,000.
Returns are outrageous. If operating expenses are kept to 33% of rents, the property would generate $4,776 per year in free cash. That’s a cash on cash return on my $20,000 of 23.8%. This does not include any potential increases in the property value, growth in ownership equity, or increasing rents in excess of additional operating costs.
Now, let’s go really conservative and say 50% of rents are used up in operating costs. Free cash falls to $2664 annually, which is a cash on cash return of 13% per year. Again, this does not include any potential increase in the property value, growth in ownership equity, or increasing rents in excess of operating costs. Basically, I’m assuming a very terrible worst case scenario.
Real Estate Does Make Sense
Finally! Real estate as an asset class does look like it’s starting to make sense. Even though the total return from this particular property is fairly small on a dollars and cents basis, the returns on a percentage basis are quite large. The question is, then, is dealing with two tenants worth cash flow of $2600-$4800 annually, plus a free duplex after 30 years of renting?