Real Estate Investing: How come no one includes equity gain when calculating RoR

[doomy]

Quick question - while reading the threads on this site relating to RE investing, it seems that everyone ignores the equity gain realized when a tenant is paying off your mortgage. i.e.: even if the net return is negative (total carrying costs > rent), the equity that the tenant is paying on your behalf will in most cases outweigh this.

Am I missing something?

[doomy]

As an example - if the landlord needs to pay 100$ per month to offset the costs, in 25 years he/she will have a property fully paid off. Even without any appreciation in the price of the property, the landlord will come out ahead.

[actng]

because my 1st year accounting prof said GAAP doesn't like it.

[Mark77]

You could do this (basically REITs would love for you to do this -- they've even invented a non-GAAP metric called "Funds From Operations" which essentially assumes that their land will never depreciate!), but when comparing to other investments, one needs to compare such to an equivalent accounting treatment with other asset classes.

For instance, the land that the CNR and CPR sits on, in theory, has appreciated dramatically since its original acquisition in the 1800s. Yet these companies aren't allowed to count land appreciation as 'profit' until they actually sell it. Ultimately a piece of land is only worth the present value of the future stream of rents it can acquire, adjusted with an appropriate discount rate for the risk inherent in the calculation from all sources.

[rfdrfd]

OP, I agree with you. In Toronto, if you pick a good location, since the condos, houses are priced so high, there is almost no way the monthly rent can cover all the monthly costs (mortgage, maintenance fee, yearly property tax, etc).

So to me, I consider a negative return for a property in a good location (that will appreciate in value) still a good investment for the long run. While we are young, accumulate 3-4 rental units. Every month, you'll have to throw in extra cash to cover what the rent doesn't, when all the mortgage is paid off in 25yrs, every one of them will have increased in value and all the rent (minus costs) is now pure income.

This is a very good way of securing retirement income. Esp. in Toronto, houses, condo prices will definitely double (already has compared to 10yrs ago, I know what I''m living in right now has doubled in less than 10yrs), or triple in 25 years.

[Mark77]

So to me, I consider a negative return for a property in a good location (that will appreciate in value) still a good investment for the long run. While we are young, accumulate 3-4 rental units. Every month, you'll have to throw in extra cash to cover what the rent doesn't, when all the mortgage is paid off in 25yrs, every one of them will have increased in value and all the rent (minus costs) is now pure income.

The same could be done with stocks. With a margin account, basically the dividends can pay the financing expense these days, so any "extra cash" goes directly to equity. RE isn't a bad investment over the long term, but there are various periods in which it can be dramatically overpriced relative to other investments, or vice versa.

Esp. in Toronto, houses, condo prices will definitely double (already has compared to 10yrs ago), or triple in 25 years.

But inflation is only 2-3%/annum which implies around a double in 25 years. And the next 25 years aren't likely to be accentuated by a pattern of progressively decreasing financing costs like we've seen in the previous 25 years.

[rfdrfd]

I don't disagree, but who here is "fortunate" or "smart" enough to put $300,000+ into one stock and that stock doubled in price?

With real estate, (speaking in Toronto), it isn't hard to know where a good location is to buy to have the value of the condo/house appreciate. Condos' along the Yonge subway line, downtown for example have all doubled in price or tripled. Looking at historical prices for 30+ yrs, those locations have only appreciated, even the market crashes of 2000, 2008 didn't crash those prices much, and all have recovered and beyond now

The same could be done with stocks. With a margin account, basically the dividends can pay the financing expense these days, so any "extra cash" goes directly to equity. RE isn't a bad investment over the long term, but there are various periods in which it can be dramatically overpriced relative to other investments, or vice versa.



But inflation is only 2-3%/annum which implies around a double in 25 years. And the next 25 years aren't likely to be accentuated by a pattern of progressively decreasing financing costs like we've seen in the previous 25 years.

[airodus]

This is a very good way of securing retirement income. Esp. in Toronto, houses, condo prices will definitely double (already has compared to 10yrs ago, I know what I''m living in right now has doubled in less than 10yrs), or triple in 25 years.

Be wary of that kind of thinking. No one has a crystal ball. A lot of people in the US had the exact same attitude and have suffered tremendously for it. Frankly I think it's best to invest in undervalued markets like Saskatchewan and Alberta. Where prices are low, rents are high and speculation is conservative.

[ccyk]

Quick question - while reading the threads on this site relating to RE investing, it seems that everyone ignores the equity gain realized when a tenant is paying off your mortgage. i.e.: even if the net return is negative (total carrying costs > rent), the equity that the tenant is paying on your behalf will in most cases outweigh this.

Am I missing something?

cos your are double counting?

[Mark77]

I don't disagree, but who here is "fortunate" or "smart" enough to put $300,000+ into one stock and that stock doubled in price?

You don't need to put it into one stock; there are index funds available, for extremely low cost, that can diversify across 50-100 stocks (or more). Historically these double every 7-10 years.

With real estate, (speaking in Toronto), it isn't hard to know where a good location is to buy to have the value of the condo/house appreciate. Condos' along the Yonge subway line, downtown for example have all doubled in price or tripled. Looking at historical prices for 30+ yrs, those locations have only appreciated, even the market crashes of 2000, 2008 didn't crash those prices much, and all have recovered and beyond now

And eventually the market gets ahead of itself and prices that stuff all in. After which, those places fall, just like the rest of the market. Much like even the best quality stocks fall from time to time (this past year, gold miners that have only been accelerating their earnings throughout the past decade, fell often by 50% or more!).

[Mark77]

Be wary of that kind of thinking. No one has a crystal ball. A lot of people in the US had the exact same attitude and have suffered tremendously for it. Frankly I think it's best to invest in undervalued markets like Saskatchewan and Alberta. Where prices are low, rents are high and speculation is conservative.

There are many places in Alberta/Saskatchewan that basically have Toronto-like prices, without the rent support. Saskatoon is especially bad -- a few hundred people in Saskatoon working in the "potash" industry (which suffers overcapacity as the expansions are mostly complete) doesn't mean the whole City is on the verge of large income increases.

[Steve98]

Quick question - while reading the threads on this site relating to RE investing, it seems that everyone ignores the equity gain realized when a tenant is paying off your mortgage. i.e.: even if the net return is negative (total carrying costs > rent), the equity that the tenant is paying on your behalf will in most cases outweigh this.

Am I missing something?

Yes - if all you're getting out of investing that much capital, is the return of that capital, then you're better off investing that capital into something else - almost anything. In other words, if I give you $1, and you give me back my $1, my return isn't 100%. It's 0%. Why would I invest in that?

What you're really banking on, in this scenario, is the appreciation of the property itself - not the repayment of your own money. That's why most people are answering what you didn't ask: "Why can't I include property appreciation in my RoR?"

I think most people who invest in real-estate with that perspective learn a tough lesson once the markets turn. Investments with a negative-cash-flow can be an anchor around your neck in bad times. That's why most people avoid them. You may be able to carry a negative/zero cashflow property now, but what happens if rates increase, or you lose your job, or you have a medical issue, etc...and suddenly you're a distressed seller in perhaps a bad real-estate market.

[doomy]

Yes - if all you're getting out of investing that much capital, is the return of that capital, then you're better off investing that capital into something else - almost anything. In other words, if I give you $1, and you give me back my $1, my return isn't 100%. It's 0%. Why would I invest in that?

What you're really banking on, in this scenario, is the appreciation of the property itself - not the repayment of your own money. That's why most people are answering what you didn't ask: "Why can't I include property appreciation in my RoR?"

I think most people who invest in real-estate with that perspective learn a tough lesson once the markets turn. Investments with a negative-cash-flow can be an anchor around your neck in bad times. That's why most people avoid them. You may be able to carry a negative/zero cashflow property now, but what happens if rates increase, or you lose your job, or you have a medical issue, etc...and suddenly you're a distressed seller in perhaps a bad real-estate market.

I think you are missing the point - the question is: someone is paying off my mortgage, why don't you include the equity that is being built into the equation. of course there is no crystal ball, but I have a suspicion that if the RE property is worth half as much in 25 years then the stock market would have also fallen.

Also everyone seems to say that rents will also dive if we enter a US scenario with a devasted RE market. From what I have read, people getting evicted from their houses actually puts upward pressure on the rents. It takes years for a foreclosed property to be coverted into a rental by the bank when there are no investors willing to buy these properties. Again, everyone uses the doomsday scenario to say that RE may be a horrible investment. The same can be said about any investment. In fact in the 6 years where everyone was predicting a RE crash in Canada (and used the premise that it's better to invest in stocks), we had a major market meltdown that wiped out so many investors and retirement funds, yet the RE investor in Canada realized much gain.

The way I see it - if I can put down 25% DP and subsidize a few hundred dollars a month for several units, I will have so much equity to play with in 10, 15, 20 years - much more than if I simply invested in stocks.

[doomy]

Yes - if all you're getting out of investing that much capital, is the return of that capital, then you're better off investing that capital into something else - almost anything. In other words, if I give you $1, and you give me back my $1, my return isn't 100%. It's 0%. Why would I invest in that?

Because in 25 years you have 10$ assuming that initial dollar was a DP (10%) and the property had 0% increase in value. Yet if you seen a steady 5% annual gain in the 1$ invested in stocks you would only have $3.23. Now factor in the property value rising with inflation, you would be much more ahead.

Sure you can buy stocks on margin but you won't be able to get the same leverage and I bet you will see a margin call over that 25 years. Probably a similar situation to renters stop paying rent, but at least you can borrow against the equity that built up to cover yourself in these "scenarios".

[Steve98]

Because in 25 years you have 10$ assuming that initial dollar was a DP (10%) and the property had 0% increase in value. Yet if you seen a steady 5% annual gain in the 1$ invested in stocks you would only have $3.23. Now factor in the property value rising with inflation, you would be much more ahead.

I thought you wanted to know why people calculated RoR or Cap-Rates in a certain way, not whether investing in a rental property vs stocks was a good idea?

I think the only answer to your original question that will satisfy you is simply because that's the way it's done. It's done that way for some of the reasons I included in my post, along with some of the others. There is no point arguing about it, that's just how it is done.

If you don't like it, then calculate your investment return any way you like, it's your money. Good luck in your endevour.