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:
*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:
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?
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.
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%.
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?
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!
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 an 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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