There are four ways to make money in real estate. Cash flow, taxes, mortgage principle paydown, and appreciation.
Three of these four are often misunderstood in how effective they are. Appreciation is one of those, and I’m focusing on that today.
Before I bash appreciation too much, here’s what the leverage lovers want me to explain first.
If you buy a house for $100,000 cash, and that house goes up by 4% in a year, the house is now worth $104,000 and you’ve made 4% on your money. Not amazing.
However, if you buy a house with $20,000 down on a $100,000 house and it goes up 4% in a year, it is now worth $104,000. You’ve made $4,000 on a $20,000 investment. You’ve made 20% on your $20,000 investment. The mortgage magnifies the benefits of the appreciation.
That’s a benefit of appreciation with a mortgage.
Of course, if you mortgage a property and it goes down in value, remember, you still owe that monthly amount to the bank no matter how low the price of the house goes. If the market crashes, you still got to pay that mortgage back at whatever price you originally borrowed for.
This was the big problem with the last real estate crash. It’s called being upside down on a mortgage.
Here is something I hear people say a lot about appreciation that makes me cringe.
It goes something like this:
“Well, I know I’m not making any cash flow on this house, maybe even losing some money, but that’s ok, because I’m in this for the appreciation.”
This attitude is especially common in high cost of living (HCOL) cities. Why?
It’s really hard to get good cash flow in a HCOL city. The price to rent ratios are way off. There is also this belief that these cities are great for appreciation, and you can’t go wrong buying because they will go up enough in value to make it worth it, even without the cash flow.
I’m here to tell you, this is not always the case.
If you want to make money in real estate, it is wise to invest for cash flow first. You want to have an investment property that makes a predictable cash flow each month. You’ll get this whether or not appreciation happens.
If the house appreciates on top of this cash flow, great.
My point is, do not bank on appreciation alone.
It’s a dangerous investment strategy. I’ll explain why.
Let’s talk first about how one makes cash flow. It’s important to understand this before we can analyze why appreciation alone as a strategy doesn’t always work.
The 1% rule
Read my article on How Much Money Will I Make From My Rental Property?
According to the 1% rule in real estate, if a property can rent for 1% a month or more of its acquisition cost, then it might be a worthwhile rental. Less than that, probably not worth it.
Acquisition cost is the cost of buying the property plus the cost of all the rehab costs of getting it ready to rent.
If you buy a house for $80,000, spend $20,000 rehabbing it, then your acquisition cost is $100,000. 1% of that is $1,000 .
If this property can rent for $1,000 or higher, it might make a good rental. Less than that, maybe not.
It is a well-known fact that you can’t get good cash flow in HCOL cities.
The 1% rule doesn’t work there!
In San Fran, a house’s purchase price will be $1 million. 1% of that would be $10,000 a month.
This house will rent for probably something like $4,000 a month. You are nowhere near the 1% rule. It’s a poor investment as a buy-and-hold rental!
So then why do people invest there?
Well, many will tell you, they are investing for appreciation.
And I’ll tell you…
People have a fundamental misunderstanding of appreciation in HCOL areas. They believe it’s much larger and more prevalent in these cities than other locations.
It’s just more visible when it happens.
You can thank the media for that. And your friendly real estate agents.
It’s true that in HCOL cities like SF, NYC, and Honolulu, it is more likely to have years where prices go up 15%-20%. This may even happen 2 or 3 years in a row.
But what people don’t realize is what happens for the next five to ten years.
What I mean by that is, even though you get these big jumps periodically in HCOL cities, on average, the appreciation in these cities over the long term is not much different than most cities across the country.
It’s not much higher than the 3% average you see nationally over the long term!
I can illustrate this perfectly with what happened on my first house in Alexandria, VA (right outside Washington, D.C.)
I bought a house in Alexandria, VA in 2003 for $280,000. I thought I was overpaying and it would be the worst financial decision of my life!
I was wrong.
Two years later, the house was worth $400,000. That’s an increase in value of 42%.
At this rate of appreciation, I’ll be a multi-millionaire by the time I retire!
I tried to buy more houses, but the prices were rising so fast, I ultimately chickened out.
I rented that house out over the next 13 years. It wasn’t a great rental. It didn’t meet the 1% rule, and therefore didn’t make much money, but I figured I would make it up on appreciation!
I sold that house in 2016.
How much did I get for it.
The price hadn’t gone any higher than what it was 11 years earlier in 2005. No growth.
If you do the math, that’s 42% / 13 years = 2.6% appreciation a year.
Wait, that’s not awesome!
To put that in perspective, over that same period, money invested in the S&P 500 would have returned 118%.
You might be tempted to say that I’m picking a certain time period or a city where it happens to look bad, but there are several random periods in HCOL areas where you will get a similarly low rate. And while sometimes in can be much higher, it can also be lower.
My point is, you have no way of knowing what appreciation rate you’ll get. That’s why you better have good cash flow, and then take appreciation if and when you get it.
Maybe the problem is the city. If you want to make a fortune with appreciation, go to the best place in the world for it.
I recently spent some time in Hawaii staying with my good friend Doug Nordman.
He retired from the Navy to never work again, unless you consider surfing and helping others retire early as work.
Check out his blog. www.the-military-guide.com
Nothing is better than hanging out with him and his wife in Hawaii.
We spend our days surfing, talking about real estate, blogs, the military, finance, and early retirement.
That might seem weird to some of you, but it’s heaven to me!
He bought two properties in Hawaii.
Maybe that’s where all his money comes from. It’s the massive appreciation from those two houses!
Everybody knows properties always appreciate in Hawaii!
Let’s take a look…
I asked him about depreciation on his two properties and he gave me a great reply via email. I’m adding his words to this post:
Without getting into cost basis and improvements and depreciation, we bought the first home as a FSBO in 1989 for $277K. 29 years later it’d sell at roughly $750K (gross before closing costs, but we’d FSBO again). That’s a 3.5% APY compounding.
We bought it at the peak of the Japan-fueled real estate bull market in 1989, but the property was in terrible shape and cheaper than the other 50 homes I viewed. We added a lot of sweat equity in the 1990s: new landscaping, new shake roof, a bathroom rehab, paint, carpet, ceiling fans, window blinds. Last year’s rehab (kitchen & both bathrooms, porcelain tile, new fence) was another $70K of improvement. Today’s market is again at a peak but we’ve added $150K to the cost basis for what is now a premium property.
Overall I’m calling the appreciation at about the rate of inflation.
As a rental, the capitalization rate has been 3%-4% for most of that 29 years. (When my spouse’s parents were living there the cap rate was zero, but that’s arguably a landlord’s emotional choice.) We’d be taxed on 21 years of depreciation recapture. The capital gains would also bounce us up into AMT territory, although it’s been a while since I researched that.
We bought our second home in 2000 for $405K. In retrospect, that year was the pit of Hawaii’s decade-long real estate recession which had started after Japan’s real estate bubble burst. The house was in horrible shape. The owners had died in 1997, the house was in trust for their teens, and the trustee was a brother-in-law who just wanted outta that job. In retrospect we stole it when nobody else would even look at it.
We poured a lot more sweat equity into this place: paint, carpets, a bathroom rehab. In 2011 we paid a contractor $120K to rebuild the family room end of the house, along with a bunch of other improvements. The photovoltaic & solar water systems would retail for $30K today but we DIY’d them in 2005 for $15K.
Last August our home appraised at $1,033,000 (we refinanced the mortgage). That’s 5.7% APY on $405K after 17 years. However the $120K contractor’s improvements and our other DIY work has raised our cost basis to $550K, so perhaps a more reasonable appreciation is 3.8% over 17 years.
I could plot our annual property-tax assessments over the last three decades, and they’d make an interesting rising sine wave. Several years ago I remember reading that Oahu’s long-term property values have oscillated around 3x-5x the state’s median income, which is barely behind inflation. The conclusion was that when the ratio was 5x we should rent and when it was 3x we should buy. However that’s probably been distorted since 2008 by the lack of new construction– both due to the Great Recession and recent zoning restrictions.
I agree with your appreciation myth! We’ve done much better leveraging our mortgages into the stock market and making the payments out of my (highly reliable) pension. I’ve tracked one 2004 refi that’s generated just over 8% after-tax on a 5.375% 30-year mortgage… and our last refi restarted that at 3.50% for 30 years.
So I’ll summarize what I take away from Doug’s situation. On his first property, both his 3.5% APY he made on appreciation over 29 years and a 3-4% cap rate is extremely unimpressive as a rental property.
It illustrates my point perfectly. Hawaii is not a paradise for real estate investors. It’s not a given what you lack in cap rate you will make up in appreciation. Far from it!
On his second property, he buys a distressed property at a low in the market, pours tons of money and sweat equity into it, and even does a $120K rebuild and adds a solar system that retails for $30K. That additional investment reduces the appreciation to 3.8% per year over a 17-year timeframe.
That’s decent, but a lot of that is forced appreciation. Take those expensive improvements away, however, and it’s less impressive.
In fact, in Hawaii the years 1988-1995 as well as 2005-2009 for appreciation were either very unimpressive or outright bad.
So I want you to stop believing that in these special cities house prices always go up, up, up, and everyone gets rich.
It’s what real estate agents like to tell you and what you read about in no-money-down real estate investing books.
But it just ain’t true!
So what do you need to know.
Out of all the ways to make money in real estate, cash flow is the most certain and straight-forward. This is something you can plan and strategize for. It’s within your control.
Appreciation is not within your control over any short amount of time. The only thing you can reasonably plan for is over a very long period you should see something like 3% appreciation per year on average.
Yeah, that’s enough to keep up with inflation, but I wouldn’t plan on buying a yacht quite yet.
Here’s my caveat before I get beat up too bad on comments.
Yes, some of you will have your story about how you bought in the right city at the right time and made a ton of money in a few years. You will claim that you are smart enough to do that every time you buy a house. In that case, you should also be a day trader.
I hope you are, but I doubt it! That was largely due to luck. I did the same thing in 2003 with my townhouse, but as you can see, since I didn’t sell in 2005, my appreciation was unimpressive because of the lack of appreciation over the following 11 years.
Maybe I’m not at good an investor as you.
Appreciation exists, and it can be magnified with the help of mortgages, but it’s not as epic as some make it out to be.
Cash flow first, and take appreciation if you get it.
Do you agree? Think I’m being unfair and cherry-picking examples? Let me know in the comments section.
I have 20 paid off properties that are cash flowing great. Read about my approach to real estate:
Rich on Money