The Age Old Investment Question: Stocks Or Real Estate? - Part II, Returns From Single Property Capital Appreciation

by: Ryan Telford

Summary

In addition to rental income, a real estate investor can benefit from returns from capital appreciation.

The sale of single family homes can provide attractive long term returns.

Like investing in the stock market, the timing of the investment can also make a significant to returns in the long run.

Investing in these properties in the short term can also result in negative returns for an investor.

(Credit: marbellaforsale.com)

In Part I of this series, we looked at the general qualities of both real estate investment and the stock market. We also looked at a specific investment case to estimate various rates of return for net rental income (or cash flow) on a single property.

Another source of return from real estate investment is through the sale of the asset. For those who have read my previous articles, I have discussed the impact that timing has in investing in the stock market. Your entry and exit points can make a significant difference in your overall return; the same applies for real estate investment.

To demonstrate this timing effect in real estate investing, we will work through a part historical/part academic "what if" exercise to see the effects of appreciation in different scenarios. As we have discussed, real estate investing in single family homes has many moving parts, and real estate markets can vary considerably by region and sub-asset class. As we did with the rental income scenarios in Part I, we will assume several parameters such as starting house value, rent, property tax rates, etc.

Appreciation Rates

In the long term, the rate at which investment properties appreciate makes most of the impact to returns. In Canada, the average appreciation rate of single family homes is approximately 5%, adjusted for inflation (source). Note that this is an average rate, and markets do not typically appreciate consistently at their average value, but instead through peaks and valleys. The figure below shows how the value of single family homes varies over time.

(Source)

This is a national average and does not reflect a specific market, however the peaks and valleys are indicative of a real estate cycle, and will continue to occur over time. Just like in the stock market, an investor's entry and exit point can make have a significant difference to his or her overall return. We all want to buy low and sell high, however at times we do not know where we are in the cycle until after the fact. To illustrate this, we will look at 4 investment periods, each 20 years in duration.

We will calculate the CAGR (compounded annual growth rate) over each 20 year period, which can be compared to investment returns in other asset classes. Our periods will be as follows:

  • Period #1, average rate of 5% appreciation rate per year
  • Period #2, appreciation rate curve as shown in figure above, 1992-2012
  • Period #3, rate curve above from 1997 - 2012 (last 5 years using average of 5% per year)
  • Period #4, rate curve above from 2002 - 2012 (last 10 years using average of 5% per year)

The table below shows annual appreciation rates for each year and period. Also shown is the appreciation of a $300,000 property purchased at year 0 of each period, and its corresponding value after each year.

(*) Yellow fields for period #'s 3 and 4 are average rates as data unavailable or future.

(Source: Author table and calculations)

Returns from Property Appreciation and Sale

For each period, we will begin looking at sale returns with one property in each period for holding periods ranging from 1 to 20 years. In Part III, we will look at various multiple property scenarios over 20 years in each period.

Composition of the Sale Return:

On the sale of the property, the net proceeds are calculated as follows:

House Sale Proceeds =

Sale Price - Mortgage Remaining - Sale Commission and Closing Costs

Our starting point for each period is one single family home priced at $300,000, with a 20% down payment of $60,000 (see Part I). The final house sale price for any period is assumed to be the initial purchase price multiplied by the appreciation rate for each year of the period. For example, in Period #1, the house value after 5 years is $300,000 *1.05 * 1.05 * 1.05 * 1.05 * 1.05 = $382,884.

Mortgage remaining is calculated based on total principal paydown up to the given year. This is calculated based on standard mortgage tables. Using MS Excel functions I created a mortgage table for a $300,000 mortgage at 3% interest, amortized over 30 years. Principal paydown and mortgage remaining are shown below per year.

(Source: Author calculations)

Sale commission consists of the payment to the real estate agent to sell the property. In Ontario, Canada, while there is little in the way of firm historical data on commission rates, 5% of the final selling price is typical (source). The 5% commission is often split, the selling agent receiving 2.5% and the buying agent the other 2.5%.

In Canada, real estate commission is also taxable. In Ontario, the 5% commission is then taxed at 13% (for a total cost to the investor of roughly 5.7%). For your specific region be sure to verify the commission and any taxes to be paid.

Closing costs include a legal allowance, costs to freshen up the house for sale and any miscellaneous costs (total of $3,000).

Our basis for return comparison over longer periods will be compounded annual growth rate, or CAGR. This is also referred to as the "geometric mean" (discussed at length here). This rate takes into account compounding effects over time, and we can compare to other investing returns. It is simply the rate that would be required each year to obtain our final sale profit with an initial investment.

As a simple example, with our initial investment of $68,500, and a net sale proceeds of $100,000 after 5 years, the compounded annual rate would be 7.86%.

$68,500 * 1.0786 * 1.0786 * 1.0786 * 1.0786 * 1.0786 = $100,000

This value is calculated using a simple MS Excel function.

One Property, Period #1

The table below shows returns after a holding period of 1 year to 20 years for one property in Period #1 (steady 5% annual appreciation), starting at year 0. All sale proceeds are before taxes.

(Source: Author table & calculations)

Other than a holding period of 1 year, CAGR is in positive territory for any holding duration time, and double digit CAGR after 3 years.

The investor's initial investment could have been doubled in between 4 and 5 years ($68,500 x2 = $137,000). After a holding period of 20 years, at a consistent appreciation rate an investor could have made nearly 10 times (pre-tax) his or her initial investment of $68,500.

These returns do not include rental income. I have purposely kept rental income return and appreciation return separate for several reasons. The rental income can be highly variant on short term effects such as maintenance requirements, vacancy, etc. For each of the holding period returns in the table above, the rental income will be additional, depending on the various rental conditions discussed in Part I.

Recall that our "worst case" rental income scenario includes up to $3,000 per year for a "rainy day" fund. With holding periods longer than 10 years it is likely that more expenses would be required to maintain the home, including but not limited to a roof replacement, furnace replacement, update or replacement of bathroom, etc.

We have also assumed a consistent fixed mortgage rate for this exercise. Note that while mortgages are amortized over 25 or 30 year periods, a borrower is typically locked into a term for 5 years with the lender. After the 5 year mortgage term expires, the rate may change after setting a new term with the lender (particularly in the rising rate environment we are in at time of writing).

Charges to discharge the mortgage before the respective term ends can apply, sometimes significant. Be sure to know in advance what sort of liability you would be responsible for if selling a property and discharging the mortgage early.

Finally, these returns are before taxes. Capital gains tax, and depreciation recapture, etc are highly variable depending on each investor's personal situation and region, so they have been excluded here.

One Property, Period #2

While Period #1 assumed a consistent appreciation rate at the historical average in Canada, in Period #2 we use annual appreciation rates that vary and that are more typical over time (annual rates as experienced from 1992 - 2012). The table below shows the calculations of returns for various holding periods in Period #2.

(Source: Author table & calculations)

Period #2 shows results considerably different from our steady 5% appreciation per year in Period #1.

If for whatever reason the investor did not like being a landlord, or needed to raise funds for some personal reason, selling the house in the short term (within 3 years) would have resulted in a loss in this period. Note that there would likely be charges from the lender to discharge the mortgage before the 5 year term ends as well (not shown)

If he or she was in for the long term, to achieve a double digit CAGR on the sale of the property it would have taken roughly 12 years. At this point, and investor would have made over 3X his/her original investment of $68,500.

Also note that our total net sale proceeds after 20 years is approximately $200,000 less than the steady 5% per year period #1.

One Property, Period #3

Repeating the exercise for Period #3 is shown below:

(Source: Author table and calculations)

Similar to Period #'s 1 & 2, selling in the short term could lose an investor money. Double digit CAGR returns are possible sooner in this scenario, at year 6. The same year an investor could have roughly doubled his initial investment.

If holding on for the full 20 years, an investor could have made over 8 times his or her money.

One Property, Period #4

Period #4 is different from the other periods in that it starts off with high appreciation rates per year:

(Source: Author table & calculations)

Assuming the average rate for years 11 to 20, performance is impressive. Neglecting taxes, returns are positive even after Year 1. Many investors would want to try and get a quick return in 1 or 2 years in a hot market like this. This is dangerous, and a drop could be right around the corner in a housing market.

An interesting point to note is at years 6 and 7. After year 6 an investor could have sold and made 3.3x his or her initial investment; waiting one more year at year 7, even after another year of principal paydown, he or she would have about $45,000 less than in year 6, or 2.6X.

The Takeaway

The point of working through these different periods is that timing really does make a difference to overall returns. While it is easy to estimate potential returns by assuming an average appreciation rate per year, in reality no market appreciates consistently, there are many bumps in the road. As we have seen there are opportunities to lose money in the short run in real estate, and for your potential net proceeds to drop in value over time.

Whatever holding period is considered, there is of course the time and effort required to sell the house, and then to buy another one if that is the objective. Perhaps the investor is happy with the tenants and is achieving good cash flow from rental income. Another option is to tap into the equity that has been accumulating in the first property over time to acquire more properties in the portfolio. We will look at various multi-property scenarios in Part III of this series.

Until then, happy investing.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.