The Age Old Investment Question: Stocks Or Real Estate? - Part III, Returns From Leveraged, Multi-Property Capital Appreciation

by: Ryan Telford

Summary

Leverage can be a powerful tool in real estate investment over the long term.

While returns can be higher with more properties, there is proportionally more work involved in maintaining the property portfolio.

As we found in single-property portfolios, timing of a multi-property investment can make a significant difference over the long term.

(Credit: Bj56.org)

In our attempt to compare real estate and stock investing, we have looked at the qualitative aspects of both asset classes, potential rental income returns in single property real estate portfolios (Part I), and various potential returns from appreciation in single property portfolios (Part II).

To sum up so far, our rental income returns ranged from -1% to 6% per year depending on our scenario. Over the long term, holding on to a single property and selling after 20 years yielded a compounded annual growth rate, or CAGR, of between 9% and 12%. Not bad when compared to a simple market return of the S&P 500 (NYSEARCA:SPY) of 5.2% since 1999 (Source: Portfolio123.com). We will look at other market returns in Part IV.

Over time, investment properties both increase in value, and mortgage principal is paid down. One of the unique features of real estate investment is the ability to borrow against existing properties in one's portfolio (or "extract equity" or "refinance") to acquire others.

Before we go any further on the subject of equity extraction, I believe there is something that should be clarified. It may seem at first glance that this equity is "your" money. In one way it is; however, it is still attached to the house, which is collateral for a mortgage. To tap into the equity, you will need to refinance the home, meaning the bank will give you access to the funds as a loan, the collateral still being the house. For this reason, it is prudent that equity that is taken on a property be used in an investment that is expected to make a return greater than the rate of interest the bank is charging you.

Another important point is that you typically cannot access 100% of this equity. Lenders' rules will vary, however, often you can only access a maximum of 80% of the equity in the home (source). There may be a maximum loan-to-value criteria, or LTV, that must be met as well. When considering this option be sure to understand the criteria set out by your lender.

The final amount of equity that your lender will provide access to and the interest rate at which you are lent your equity will be subject to other factors such as your credit rating, income, etc. If the lender feels that based on your income you would only be able to service debt on 50% or 60% of the property, then that may the maximum you have access to. Each investor's situation is different, and should be considered when planning portfolio expansion.

The Methodology

We will look at different scenarios for extracting equity on existing properties to acquire new ones.

To look at the effects of equity extraction, it would be instructive to look at different periods with different appreciation periods. We will use the same periods we used for our "buy and hold" single property scenarios in Part II.

The appreciation rate will be applied to determine the value of the subsequent properties after year 0. Recall that the initial value of our first single family home property is $300,000. As we applied the appreciation rates to determine the market value for sale purposes, we will also use the same rate to acquire subsequent properties. For example, property #1 at Year 0 is $300,000. For Period #1, to buy an equivalent single family home, we will assume the market value is now $300,000 * Year 1 Appreciation * Year 2 Appreciation…*Year 5 Appreciation:

Single Family Home Price @ Year 5, Period 1 =

$300,000 * 1.05 * 1.05 * 1.05 *1.05 * 1.05 = $382,884.

We will acquire subsequent properties only once we have enough accessible equity in the first property to cover the 20% down payment and closing costs for the subsequent property. Recall that lenders will typically lend up to 80% of the appraised or market value of the property being refinanced, less the existing mortgage balance. For our purposes, we will assume that the investor has a sufficient credit rating for the lender to refinance to 80% equity.

We will look at several equity extraction scenarios, from taking equity out slowly over time to taking it out as soon as it is available to acquire as many properties as possible. This will be done within a holding period of 20 years. At the end of 20 years, all properties will be sold, and a total CAGR for the 20 year period will be determined.

We will complete this exercise for each of the appreciation periods in Part II, i.e. consistent 5% appreciation per year period (#1), and also with our other variable appreciation periods (#s 2, 3 & 4).

The Worksheet

As described above, we will extract equity once we have sufficient accessible equity to cover the 20% down payment of a single family home plus closing costs. The worksheet below shows house appreciation, mortgage remaining and accessible equity for each year Period #1.

(Source: Author table and calculations)

The top horizontal x-axis shows each year of the period, and the value of our initial $300,000 house after appreciation in the given year. Included is a breakdown showing the acquisition price (down payment plus closing costs) at each acquisition/purchase year. For example, in the table below, at year 10 a new single family home is assumed to cost $488,688, with a total investment cost of $106,734 (blue row). If we wanted to purchase a second property at year 10 in our investment period, our first property would need accessible equity of at least $106,734.

The vertical axis shows several statistics for each property at the given year. The yellow row fields show principal paydown; green is the remaining mortgage balance. Blue rows indicate the accessible home equity (or HELOC, home equity line of credit) available after each year. The blue rows can then be compared to the blue total initial investment cost of properties in future years at the top of the table.

For example, at year 5 of possession of our first property (vertical axis), accessible equity is $92,932. Then we look at the top light blue row at the top of the table. At year 5, the total initial investment cost of a single family home is $85,077. After year 5, we would have sufficient equity in Property #1 to acquire Property #2.

After equity is taken out of the first property (or refinanced), that amount is considered a loan against the first property. For our purposes, we will assume that only interest payments are paid against the HELOC, and will need to be accounted for in the rental income. The HELOC balance is considered a liability once we sell the first property. In extracting additional equity from the property requires the first HELOC balance be subtracted from the total available equity.

The table also provides house values at the end of year 20, and we can estimate total net proceeds after sale.

The table above is generated for each period.

Period #1

Scenario #1:

Acquire two properties from Property #1 at year 11 once equity is available for #2 and #3, and sell all three at year 20.

(Source: Author table and calculations)

Scenario #2:

Instead of waiting to have enough equity to buy two properties at the same time, let's see what happens when we buy the second property once we have the equity from Property #1, and the third property once the equity is available.

(Source: Author table and calculations)

In this scenario, acquiring the second property as soon as enough equity was available would have provided nearly $200,000 extra at year 20, and nearly 0.82% extra in CAGR (over 20 years, each 1% can make a material difference). An investor could also potentially benefit from additional rental income in acquiring property #2 sooner (more on rental income after equity extraction in Part III).

Scenario #3:

Now let's use the equity from Property #2 to buy Property #4.

(Source: Author table and calculations)

Once again, we have increased our overall net sale proceeds, this time by roughly another $300,000, with an annual CAGR of 17.6% (nothing to sneeze at). Keep in mind that we are progressively adding more properties to our portfolio, meaning that with these added returns we have a correspondingly increasing number of properties to care for, maintain, and potentially incur major repair costs over time.

Scenario #4

Now let's maximize the number of properties in our portfolio by extracting equity as soon as it is available in each property (in other words, let us maximize leverage to make as large a property portfolio as possible). For Period #1, see below for a tree diagram showing how each property is used to acquire the next.

(Source: Author table and calculations)

The breakdown of total net sale proceeds after selling seven properties:

(Source: Author table and calculations)

With maximizing the number of properties in our portfolio, we end up with net sale proceeds of nearly $2.17M (before taxes) at year 20, and a CAGR of 18.86%. An excellent return to be sure, but the same comment regarding multiple properties from Scenario #3 applies even more so. From years 15 to 20, the investor would be a landlord to seven properties, or seven families. At this stage, you are truly running a business, and may be on call for a variety of duties or reasons.

Lending Limits

Another important consideration is how many mortgages a lender will allow an investor to undertake. This number can vary depending on the institution and the investor's situation. Anecdotally, many investors that I have spoken to in Canada have suggested that the major lenders limit mortgages to 4 to 5. (I am unable to find any lender publishing their limits, likely because it depends on each investor). After this point, other options include private lenders, where rates can be different than conventional lenders, and would need to be taken into account.

Period #2

Where Period #1 assumes a consistent historical appreciation rate, our other periods use appreciation patterns similar to what has been experienced in Canada since 1992. Let's see how these different property acquisition scenarios performed in Period #2.

Our worksheet for Period #2 is included below:

(Source: Author table and calculations)

Scenario #1 - Acquire Two Properties from Property #1

In this 20-year period, waiting to buy two properties from Property #1 would take 14 years. Selling all three properties at year 20 would provide a pre-tax net sale proceeds of just over $730,000, and a CAGR of 12.58%.

(Source: Author table and calculations)

Scenario #2 - Buy Two Properties Once Equity is Available in Property #1

Similar to Scenario #2 of Period #1, investing in a second house once the equity is available results in a greater profit at year 20. The other advantage of buying the second property before the third is that the investor can transition into the role of multi-property landlord gradually, as opposed to going from one property to three as in Scenario #1.

(Source: Author table and calculations)

Scenario #3 - Use Equity from Property #2 to Buy Property #4

Once again, with additional properties overall net sale proceeds increases (we have broken the $1M threshold), as does CAGR over 20 years.

(Source: Author table and calculations)

Scenario #4 - Extract Equity Once Available (Max Leverage)

For Period #2, see the tree diagram below on how we acquire several properties from Property #1:

(Source: Author table and calculations)

The table below shows net sale proceeds from each of our seven properties over the 20-year period:

(Source: Author table and calculations)

In terms of Period #2, this scenario provides the greatest CAGR of nearly 15.5%, but 3% less than Period #1. Over 20 years each percentage point has a significant effect on absolute return. Where this scenario yielded net sale proceeds of $2.17M (pre-tax) in Period #1, the same scenario in Period #2 yielded only $1.22M; this is only 56% of what was achieved in Period #1 for the same number of properties.

As we noted in the single property scenarios (Part II), the basis for appreciation can have a significant difference over long periods, and investors should take this into account when planning into the future.

Period #3

For Period #s 3 and 4, summary tables are presented for each scenario, followed by an overall summary table of all scenarios in all periods.

Worksheet

(Source: Author table and calculations)

Scenario #1 - Buy Two Properties from Property #1

(Source: Author table and calculations)

Scenario #2 - Buy Two Properties once Equity is Available

(Source: Author table and calculations)

Scenario #3 - Use Equity from Property #2 to Buy Property #4

(Source: Author table and calculations)

Scenario #4, Extract All Equity Once Available (Max Leverage)

(Source: Author table and calculations)

(Source: Author table and calculations)

Period #3 resulted in a maximum portfolio size of eight properties, and a pre-tax net sale proceeds of just over $2M, significantly more than our Period #2.

Period #4

Worksheet

(Source: Author table and calculations)

Scenario #1 - Buy Two Properties from Property #1

(Source: Author table and calculations)

Scenario #2 - Use Equity Once Available

(Source: Author table and calculations)

Scenario #3 - Use Equity in Property #2 to Buy Property #4

(Source: Author table and calculations)

Scenario #4 - Extract Equity Once Available (Max Leverage)

(Source: Author table and calculations)

(Source: Author table and calculations)

Scenario #4 in Period #4 provides the greatest return out of all of our scenarios, with net sale proceeds of nearly $2.8M (pre-tax) after 20 years, and a CAGR of 20.33%. This is our fully leveraged portfolio, and again the investor would need to verify what lending options were available for multiple mortgages.

Multi-Property Scenario Comparison

The table below summarizes all of our returns for the various scenarios in the different periods:

(Source: Author table and calculations)

As is to be expected, returns gradually increase with the more properties that are acquired in a given period, even after all costs are accounted for (pre-tax). Bear in mind that with more properties, there are proportionally more expenses and effort required to maintain the portfolio. In Scenario #4, an investor would have up to nine families who he or she was responsible for. Compared to owning one single investment property, this is up to 9X more service calls, 9X more complaints, 9X more emergencies, etc. Of course, this will depend on the state of the house and the personality of the tenants.

The key takeaway is that while more properties can potentially provide very handsome returns, this is also under the assumption that the properties are all held during the period (Holding a full nine properties could prove challenging for some investors).

On the plus side, with more properties, there is also the opportunity for more rental income. Before we get too excited, recall that extracting equity from an existing property to finance another is not cash, but a loan against the property the equity is being taken from. In our multi-property scenarios above, our basis was that interest payments were made on each HELOC and the principal would be discharged at year 20 after the sale of all properties.

In Part IV, we'll take a look at potential rental income in multi-property portfolios, with HELOC interest payments taken into account. We'll also look at several stock market investment scenarios to see how they have fared against our real estate returns.

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.

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