In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part two of our series takes a look at the positives and negatives of real estate investing.
After deciding against purchasing the liquor store, my next move was onto real estate. I have several friends that thrive in the area of real estate investing and have learned that hiring a management team can provide relief from having to do the maintenance and the management yourself, so I began the search.
I focused primarily on residential properties as well as multi-family units.
I had determined that I wanted to get at least a 10% return with this investment. Looking at the real estate industry, I figured I could get a minimum of a 7% return and in some cases, as great as 17%.
Recognizing the Three Components of Return
All investments have three components of return: earnings or cash generated each year, growth of earnings, and (hopefully) increase in valuation. Earnings are the cash flow that is generated and paid to you. The growth of earnings is the increase in those expected earnings over a period of time. Last, the increase in valuation is the upturn in price per unit from the time you buy to the time you sell.
In terms of stocks, earnings are dividends that are paid to you. If a particular stock is paying a 10% dividend yield, you as the investor can expect 10% from dividends. The increase in earnings is the rise of dividends each year paid out to you. If the stock was purchased for $10 and the dividend was originally $1 per share, but increased to $1.30 over the course of five years, then the increase in earnings was 30% total, or 6% per year.
Last, you might have purchased the stock for 10 times a dollar of earnings and sold for 15 times a dollar of earnings. This represents a 50% increase in the valuation over five years, or 10% per year. As a result, you would have a total annual return of 26% per year: 10% for dividends, 6% from growth in earnings, and 10% for appreciation.
Wouldn’t a return like that be nice to get now a days? Unfortunately, the stock market has only averaged about 4.5% a year for the past 15 years.
Looking into the real estate market, I found homes that I could rent and expect to receive a 7% return from the rental income. I estimated I could increase the rent by 2% per year, and expect to see a 1% increase in the valuation.
I looked at buying a home for $150,000 and charging an annual rent of $10,750 or 7%. I could expect the rental income to increase from $10,750 in the first year to $13,450 at the end of a five-year period; roughly a 1% increase per year. At the end of five years, I could anticipate selling the property for $165,000, which in total would earn me a return of 10%. This would be good!
The Reality of Real Estate Investing
However, weighing into this grand plan would be the cost of annual maintenance, the expense of personally managing the home or hiring a property manager, and the toll of having a potentially unruly renter.
In the end, I decided that although I might be able to earn a great return on a real estate investment, I would still have to put up with the risk and hassle of managing the rental to some extent, in which the costs may outweigh the benefits of such a return.
My next FLOW post specifies how and what I decided to invest in.