Equity Doubling – The Secret Sauce of Rental House Investing

Mike Nelson
Mike Nelson

The Gift of Double Equity!

According to several sources, including Investopedia.com, the average annual return from the stock market during the previous 30 years is about 10%.  Adjusted for inflation they calculate the average annual return at 7%.

According to the US Census, the prices for new homes between 1963 and 2008 increased at a rate of 5.4% per year.

According to the National Association of Realtors®, the average rate of appreciation for all houses has been 3.7%.

And according to Kevin Michels, with Medicus Wealth Planning, based on the performance of publicly traded REITs, the average annual return for real estate between 1970 and 2016 was 11.42%.

So if stock market investments grow at 7% per year, and real estate appreciates at a rate of 3.7% per year, why would an investor buy rental houses?  In short, “equity doubling” or leveraging to enhance your accumulation of wealth.

STOCK MARKET ANALYSIS

Above we assume a 25 year old investor puts $30,000 into the stock market, and that $30,000 grows at a rate of 10% per year.  Since it’s not typical that an investor would leverage their stock purchase, that investor at the time of his/her retirement (approximately 40 years) would have an investment now worth $1,234,000 (no adjustment for inflation).

RENTAL MARKET ANALYSIS

However, suppose the same investor purchased a rental house, using the $30,000 as a 20% down payment on a $150,000 rental house.  Suppose the average appreciation rate for the next 40 years is only 3%.  And suppose that as the equity in the house grows the investor uses the additional equity to purchase a 2nd house, then a 3rd house, and so on.  In the 7th year, the investor can purchase the 2ndhouse even considering that the purchase prices continue to increase at market rate and consequently, that the 20% required down payment also increases. Over the course of 40 years the investor ends up with 8 houses that appreciate from the year of purchase forward at the assumed appreciation rate of 3%.  Without adding any cash to the initial investment of $30,000, at the end of 40 years the investor is entering retirement with over $3 million in equity (no adjustment for inflation).

You might wonder how an investor can access their accumulated equity to make additional purchases.  Two straight forward options include 1) a cash out refinance or 2) selling one to buy two by way of a 1031 tax deferred exchange.

It’s important for investors to understand how appreciation affects investment returns for rental houses.  For every other form of rental real estate investments, such as apartments, retail, or office buildings, the sale price of the property will be a function of Cap Rate and Net Operating Income.  But this is generally not true with rental HOUSES.  When the investor sells the rental house, the typical buyer is an owner occupant who doesn’t care what the NOI is.  They care about how good the local schools are, how long the commute to work is, and many other amenities.  When rental house investors buy houses with an emphasis on Cap Rate, they often end up purchasing lower quality C or C- properties based on potentially higher cash flows but these houses will not appreciate as rapidly.  Rental house investors need to focus on Internal Rate of Return (IRR) which will encompass ALL aspects of the investment including appreciation, cash flow, and loan amortization.  When appreciation is factored in, we often find that B, B+, and A- properties often have the higher IRR because of the rate at which they appreciate.

We’re not trying to promote investing in rental houses rather than investing in stocks.  We are illustrating that investing in rental houses is a great way to diversify your investment portfolio and enhance your retirement.

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