Infinite Returns

Infinite returns

The other day, I had a call from my relationship banker across the pond.

Now, I have no idea why I have a relationship banker. I’m far, far away from meeting the definition of an ultra-high-net-worth individual, for whom such niceties are usually reserved.

I’ll take it as far as to say I am reasonably confident I will never meet that definition.

I’m also pretty sure my bank knows that as well.

Still, they must have decided that I’ll be more receptive to suggestions that come from a “dedicated relationship banker” than Call Centre Joe.

In any event, the chap called me with a suggestion that related to the very first property I’ve ever bought.  It’s currently worth about $570k and has a $410k mortgage on it.

His bright idea?

Refinance the mortgage to 80% LTV, allowing me to take $46k off the table. Presumably to buy more real estate, or simply spend the cash.

It was a short conversation, not least because of the $10k break fee on my existing mortgage (I suppose intended to cover the costs of a long-distance call).

More broadly, I don’t like pushing leverage to the hilt and the existing mortgage is giving me the right level of tax shield.  Thus, I politely declined and hung up.

What I did end up doing, however, is running the latest math on how that first investment, all the way back in 2010, had ended up working out for me.

Cash Is King

It was a straightforward exercise, with my cash outflows and inflows summarized below:

Property returns

*Denotes cash shortfall (rental income less mortgage and other expenses)

Plug the numbers into a spreadsheet and a simple XIRR formula spits out the annual return of 19.0%.

Definitely not up there with Bitcoin and GME.

Equally reasonably ahead of the magic money machine and its exceptional ~14% return over the past decade:

Recent S&P 500 performance

A Matter Of Definitions

I once read an article on real estate investing that introduced the concept of “infinite returns”.

To be candid, that catchy title was the very reason I read the article in the first place.

I mean, who doesn’t want to generate infinite returns? Answer: even people who know they don’t exist.

Anyhow, the writer came up with a very nifty definition of such returns.

He claimed that as soon as you’ve taken your down payment off the table (either via cash flows or a mortgage refinance), your initial investment is equal to zero.

Correspondingly, all future gains don’t require any initial capital – hence the infinite returns.

Catchy and creative. At the same time, wildly inaccurate.

By this logic, anyone who doubles their investment can claim to have reached this infinite return territory.

Having dismissed that appealing concept, I asked myself a different question:

What were the key drivers of the 19% return above? And given I’m currently in the market for yet another property, how can I replicate that investing success?

Value Creation

Clearly, price appreciation had something to do with it.

Over the past 11 years, the property value had increased from $339k to $570k.

A 68% total increase. On an annualized basis, around 4.8%.

Certainly healthy, and well ahead of inflation.  In line with the price rises in London over the past decade.

At the same time, far below the growth in the noughties, which created hundreds of thousands of property millionaires from scratch.

London price growth

Source: ThisisMoney.co.uk

Most importantly, the price growth is in line with the growth in rents. In other words, the P/E ratio of this property has not moved.

Wait a minute, you’ll say. But what if you hadn’t gotten so damn lucky?

What if rents and house prices only went up in line with inflation, let’s say 3%?

Thankfully, I’ve got my trustworthy spreadsheet to answer that question.

The property would have been worth just $469k as of today, about $100k less than it does.

My annualized returns? 15.7%.

Property returns - 3%

Hmm. That sounds punchy, doesn’t it?  Who knows if property values will go up that much going forward, Covid and all?

Let’s try 0% instead.

This one hurts.  To take me all the way back to $339k, the property market would have to crash about 40%.

I would be underwater on my mortgage to the tune of $71k.  Infinite returns, working the other way.

Painful, but possible.

And what would my annualized returns be in this scenario?

8.6%.

Property returns - 0%

Now, I am making a few simplifying assumptions in my analysis.

It’s true that if the price had stagnated all the way through, I would never be able to take $214k off the table back in November 2018.

Equally, house prices rarely move in a linear fashion. Instead, they follow the classic boom and bust cycle.

I am also ignoring taxes. That being said, any property investor worth his (or her) salt always has a few (legal) tricks up their sleeve to minimize the tax liability.

What it boils down to, however, is a few very simple facts:

#1: Over the long run, cities with healthy economies and demographics are bound to see reasonable price growth.

This is especially true in segments where supply is inherently limited (such as detached, freehold homes).

#2: While price growth is important, it’s not crucial…

As a matter of fact, assuming above-inflation price increases is not a good idea.

If things work out that way, treat it as a bonus. Just don’t count on it.

#3: … but cash flow is.

Your property doesn’t have to be cash flow positive. Mine certainly wasn’t.

Equally, even getting to a “cash neutral” point leaves you in a great place, as evidenced by the 8.6% scenario above.

The tenant pays off the mortgage.  You refinance every couple of years, taking money off the table.

Rinse, repeat. But most importantly:

#4: Give it enough time

And that’s the biggest secret of it all.

For the first 8 years, I took zero money off the table.

I probably won’t touch it again for at least another two years.

And I certainly won’t sell it anytime soon. Why crystallize all the transaction fees and taxes?

In the meantime, it might go up or down. I’ll certainly have to keep dealing with tenants.

Not very exciting. But precisely how people get rich with real estate.

It’s Never Easy

As they say, everything is crystal clear in hindsight.

One could criticize me for sitting in front of my laptop 11 years later, theorizing on what works and what doesn’t.

Similar investment opportunities just don’t exist anymore!

Perhaps.

And yet, I’ve got another spreadsheet open on my laptop right now.

A $1.4m, 3-bedroom detached house.

Not massive, but in a great neighborhood and within a 10-minute walk of the subway.

Nicely renovated and instantly rentable for about $4k a month. At the same time, sitting on a great lot, allowing for a complete tear-down and re-build in a decade.

A roughly $600k total investment required, generating an ~8% return with very conservative assumptions.

11 years ago, that $70k was pretty much all I had. Thankfully, that’s not the case with the $600k investment I am contemplating.

Still, it’s a proper chunk of money – and it feels uncertain.

What if interest rates (finally) rise?

What if property prices crash?

What if x / y / z goes wrong?

Time will tell.

Playing the game always means you can end up a loser. It is also a pre-requisite to winning.

But at least I am willing to put my money where my mouth is.

Thank you for reading!

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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker.  I am passionate about capital markets, behavioural economics, financial independence and living the best life possible.

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11 Comments

  1. Long time reader now BoF and always thoroughly enjoy your articles. I see you always invest into property across the pond rather than in the UK. Appreciate everyone’s tax situation is different but do you wrap your property ownership into a company or trust overseas out of interest? Still learning the ropes and considering a property overseas but wondering if there are any considerations on that front with respect to structuring.

    • Thanks KoF.

      I do both, but it’s all driven by tax reasons.

      Commercial properties go into a corporation. Single-family properties are held in our names. That being said, I’m a dual citizen which makes things easier for me.

      Otherwise, I’d probably go the incorporation route as it allows you to retain earnings in the corporate vehicle and time the payments to yourself based on your overall tax requirements.

      • Thanks BoF. Helpful colour. Was thinking of this in a similar vein.

        I regularly have spreadsheets on properties and planning to go deeper as part of the overall portfolio.

        Best of luck with the detached house and super impressive returns. I usually model out rent at CPI and value at CPI as my base case but my returns definitely don’t look as frothy probably as a function of price of where I’m from. I’ve given up on the idea of UK BTL myself…

        • Same here on UK BTL. Would be much easier to own a property here but comments for readers in a few other posts have dissuadeded me.

  2. Hi Thanks for the post. I made a rookie mistake 6 years ago when I purchased a BTL unencumbered outside london. All my money is tied up and I have 100k equity and I max out on pension allowances and isas as well. With the benefit of hindsight I would have bought the property with a mortgage and used up the pension allowances 6 years ago. Am reluctant to use the equity for another BTL. Not sure how I can put the equity to good use now.

    • Am sure you have thought of it, but any way to take out a BTL mortgage on the property? Appreciate they aren’t as easy (and rates aren’t as low) to come by as residential mortgages these days.

      Could also help with the tax situation if you were to put it in a corporation.

  3. How is the London property market nowadays w/ COVID and Brexit? One of my regrets was not buying London property back in 2012 when I had the chance! I figured, who the heck was gonna manage it while I was in Sf?!

    But looks like I have a chance to buy Manhattan property now. Another regret from not buying in 2000.

    Sam

    • Prices have held up well post Brexit and actually rose quite a bit last year on the back of stamp duty holiday.

      The biggest uncertainty is population growth going forward. About 800,000 people left London during the pandemic and given we are not part of the EU anymore, they won’t be able to come back that easily (if at all).

      The other challenge with rental properties is the new tax regulations. If you hold properties in your own name, you lose all deductibility for tax purposes (including mortgage interest). If you do it via a corporation, the mortgages are much more expensive.

      So all in all, it’s a questionable proposition at the moment, which is why I only invest back across the pond.

  4. I have one BTL property ( fully offset mortgage on it ) and recently considered buying another property. My BTL property is presently on a 2 year consent to let ( offset residential mortgage ) deal that expires in 6 months. At that point I’ll either need to clear the mortgage, convert to BTL or move back into the property. The current tenant is on a cheap rent as it suited me at the time to rent it quickly without performing any required cosmetic upgrades. He’s understandably keen to keep renting the property.

    I’m struggling to find the best approach with that property. The mortgage is an offset mortgage so, all things being equal I’d probably make more money by drawing down the offset mortgage ( rate of 1.51% ) and investing the funds. I’d either keep the property empty ( which would cost additional council tax ) or move back in.

    Other approaches would either involve having a lot of money tied up in the property ( clearing the mortgage ) or taking some money out of the property and converting to BTL which would cost more and reduce the rental yield.

    When I considered buying another property I was put off by the extra 3% stamp duty. The overall tax treatment of the rent also wasn’t great

    • Hmm, doesn’t sound like you’ve got a lot of options here, courtesy of the wonderful BTL regulations in this country.

      I suppose at the end of the day it’s about figuring out which option gives you the highest return on invested capital (presumably both will be below what you are generating today).

      Not having seen the numbers, I would think that converting to BTL would win.

      Yes, the yield would reduce but you will keep a (largely) passive income asset and release capital that can be invested in higher-yielding endeavours elsewhere.

      • I think you are right about converting to BTL. Giving up the offset mortgage will be painful though as it offers a lot of flexibility at a very low rate (1.5%). I’m at a bit of a pivot point in my work / life journey where there a few significant decisions to be made. I had been using salary sacrifice aggressively for the pension tax benefits but I’m approaching LTA and I’ve used up all my carryover allowance.

        Therefore, I’m seeing an increase in tax exposure in a lot of areas which is a bit painful. Potential tax bill if I exceed LTA, larger income tax bill as I can’t pay as much into my pension as I used to, extra 3% stamp duty if I buy another property, potential CGT bill if I dispose of my rental property, lower net yield on my BTL property if I convert to BTL financing.

        I also have the added headache of my tenant now requiring 6 months notice due to the covid restrictions. As a result I’ve decided to not renew the 6 month Assured Shorthold Tenancy agreement and let it run on a monthly periodic basis. Maybe the covid notice periods rules will change before my consent to let expires in July.

        Time to update my spreadsheet and model a few scenarios.

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