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Cash Flow vs. Appreciation
In my first post on the multiple dimensions of real estate as an investment I stressed that from day one the most important aspect of a deal is cash flow. I also stated that counting on appreciation in real estate is akin to gambling. I stand by these statements and would like to fill out a little more on what I didn't write in that post. While it is easy to become excited when an investment is rising quickly, remember than most investments have market cycles. The picture above is a good example. I like investments that are good when they're going up as well as when they're going down, that way I can consistently be excited about them rather than riding the emotional roller coaster that typifies average investing in almost anything.
What is Appreciation?
My simplest definition of appreciation in real estate is this: After everything else, it's the icing on the cake and this cake tends to have gads of icing (unless you're my daughter, think about cream cheese icing and this is a much better metaphor).
While counting on appreciation in real estate is dangerous because nobody has a crystal ball, it usually becomes one of the most beautiful tendencies of real estate. It is also backed by an economy based on fiat currency; which means that real estate, in a way, is insured against long term depreciation. As long as governments print money and inflation exists, appreciation will be seen in real estate as a general trend. The beauty of real estate appreciation is that it moves faster than stated inflation rates. I just looked at the average of the last 20 years of inflation and calculate this to be 1.811% per year. In Calgary, over the same period of time, houses have appreciated more than 6.5% (which I've heard is the national average by many investors). That's quite a difference. Even if you go back 40 years, which includes the period of time when inflation rates skyrocketed all over North America, real estate beats the average by quite a bit.
Sorry For Nerding out There...
After a couple of deep breaths and a reminder that most people don't like numbers as much as me I'll get back to my main point.
Not all property appreciates at the same level. You've heard it said: Location, Location, Location. Well, it's true. Location largely determines what kind of appreciation you can enjoy over a long period of time (Remember, not count on! Simply enjoy when it comes about). If you have done your homework (and you should be able to after reading a few months of this blog), then you will be saavy enough to understand what the city is planning to do in the next 5-10 years as well as the next 20 years. That way you will know that a new light rail train line will be extended into certain areas (which tends to increase house values at a quicker rate).
There are more aspects to location that will matter in the future. As the city grows:
1. A quiet cul-de-sac will provide more value than a busy street corner
2. Access to mass transit will provide more value than difficult to access properties
3. Inner city tends to consistently increase in value whereas certain suburban areas can begin to slow down at times. Area and access are very important factors in this process.
4. Economics and crime will play a factor in certain neighborhoods (I can think of a few areas in Calgary that were clean, bright, new, and filled with young families 25 years ago and are now considered dangerous by many)
5. Style and demographics will play a role. With an aging baby boomer population that will eventually move around slower and with more difficulty, bungalows will become the only cost effective option and two-storey houses will not see the same rate of appreciation
Some More Numbers
My favorite aspect of real estate appreciation is that I never buy a property with cash. With 20% down on a piece of investment property the natural appreciation (no matter how high or low) multiplies. An oversimplified example is that if real estate tends to appreciate at 5% each year and you put down $20k on a property you purchase for $100k (20% down). When the property is worth $105k at the end of the first full year, your money in the property has just increased by 25%! Look at this again:
$100,000 = Purchase price
$20,000 = The money you put into the property (80,000 mortgage)
$5,000 = Increased value after 1 year
$25,000 = How much money you would have if you took it out after the first year
This oversimplified example doesn't even take other factors into account (keep reading because real estate looks better and better the more you understand it), but it does begin to separate real estate from other investments because it can be leveraged. I've never heard of anyone getting into low risk stocks by getting a bank loan for 80% of the investment! When stocks appreciate, your money grows at the same rate. When real estate appreciates, your money grows even faster.
Oh No, I Feel My Inner Nerd Rising
I believe some people don't realize how the numbers actually work with stock appreciation. The US has basically said that inflation has stayed around 3% for years now. If this is true (many would argue that governments under report inflation rates based on CPI criteria) lets take the recent run up in the Dow Jones (15,409.39) and compare it to the previous peak in October 2007 (14,164.53) the difference doesn't even allow for inflation. We would have to go back to 1999 in order to get the peak of the Dow Jones with inflation adjustments. What this means is that if the market simply increased at the same rate as inflation in the same period of time, it would be even higher than it is today. Here are the numbers so that you can clearly see what I'm attempting to convey. at the turn of the millennium the Dow was sitting at around 11,500. Let's inflate this number by 3%/year and see what it would sit at today...
Over 17,000!
The stock market hasn't beat inflation for the past 15 years! Some say that if you go back far enough the market does beat inflation and it even beats real estate. I won't argue because it doesn't matter very much for what I'm about to submit to you. Appreciation and counting on appreciation (remember I call this gambling) is what the average individual must count on with stocks. While dividends exist as well as higher risk advanced strategies (options and puts as well as futures and combinations of them all), that's not what most people point to when trying to convince you that stocks are the way to go. The argument usually only comes down to gambling/prospecting. Remember to continue reading future posts as I continue to build an argument for real estate as the most preferred investment anyone should have. Don't worry, I won't always pick on stocks. I'll attempt to compare the investment that others argue for in any area of the field (which means I'll pick on gold and silver as well as diamonds when it comes to physical assets).
What Am I Really Saying About Appreciation?
I'm saying it's beautiful! Don't count on it because it isn't what makes any single deal a good one. Every deal is good based on the risk to reward ratio it provides at the time of purchase. If you never have to worry about it because it puts money into your pocket each and every month, then it is an investment. If something costs you more than what it gives you along the way, it's actually a liability (and very risky prospecting). Once the investment already makes sense, then put everything in you favor so that you are able to enjoy appreciation when it comes. Trust me, it's tasty icing... Even for adults.
If you would like to learn more about investing in real estate please contact me at the email address listed at the beginning of this article or go to my website at: www.akerahomes.com/investing-in-real-estate.html
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