With housing prices skyrocketing as they currently are, it’s understandable that most real estate investors are fixated on price appreciation as the benefit real estate investment has that far and away exceeds any other.
If another benefit competes with price appreciation in the minds of most investors, it’s cashflow. Indeed, many new investors (as well as many self-anointed “gurus”) like to talk about getting to $2,000 or $3,000 or $5,000 or $10,000 a month in positive, passive cashflow.
“Just sit back and collect checks!” They say.
Both of these things are advantages of real estate, of course, but the price appreciation we are seeing now is an aberration and cashflow should only be seen as the cherry on top.
Historically speaking, house appreciation has been just higher than inflation. This is nice and when you add in leverage, it’s even nicer (four percent appreciation on a property with an 80 percent loan turns into a 20 percent gain). While there’s no way to predict when the housing market will cool off, correct or even collapse, we can say for certain that the 10 to 15 percent annual price appreciation rates we have been seeing will not last forever.
As far as cashflow goes, with houses in particular, most of it gets put back into the property. You may make $200/month, but then have a bad move out and turnover and lose all of that profit. Capital improvements such as replacing the roof, HVAC, siding, etc. usually eat up a lot of your cashflow and oftentimes all of it.
But don’t feel disheartened.
I am convinced that real estate is the best way for someone of modest means to become independently wealthy. But it’s through all the advantages of real estate that people gain wealth, not just appreciation and certainly not just cashflow. This includes tax advantages like depreciation and the ability to use leverage while also being able to buy undervalued properties because real estate is an inefficient market.
But one advantage that gets way too little attention is principal paydown.
The Power of Principal Paydown
Apartment syndicator Joe Fairless emphasizes there are “Three Immutable Laws” of real estate investing:
- Buy for cashflow [i.e., do not speculate on assets that will eat up cash]
- Secure long-term, low-leveraged debt [lower interest rate than private money PLUS principal paydown]
- Have adequate cash reserves. [i.e., save for a rainy day and have the flexibility to jump on opportunities quickly]
The first law isn’t as much about making so much through cashflow that you become rich. It’s mostly about making sure the asset is sustainable, doesn’t eat away at your cash reserves (Law 3) and can sell at its top market price. But when you add Law 1 to Law 2 (cashflow plus principal paydown) your return is substantially more than just the cash coming in.
This is because each bank loan is amortized. You pay both interest and principal each month. And each payment going to the principal reduces the amount of debt attached to the property.
While this doesn’t come back to you as hard cash, it does increase your net worth. And any real estate investor worth their salt knows that the key number to look at is net worth.
To illustrate this point, I performed a simple calculation to show what the internal rate of return would be with just principal paydown. (Internal rate of return or IRR is superior to a simple Return on Investment or ROI because it accounts for WHEN money is received; earlier is better.)
Of course, this is not actually a “return” since there’s no cash here, just equity. But the point should suffice. Here are the assumptions:
- Purchase Price: $100,000
- Down Payment: $20,000
- Loan: $80,000
- Amortization: 20 Years
- Net Cash Flow: $0
- Appreciation: 0%
The last assumption is borderline ludicrous. During the last 20 years, only one of the 500 biggest cities in the United States has failed to appreciate in value (Flint, MI). And the 2008 Housing Crisis occurred during that time.
Even still, if you were simply to hold a property with a 20-year loan for the entire 20 years with no cash flow (the rent paying only for all property-related expenses) and no appreciation, the rate of return is pretty good. Using the CCIM Financial Calculator, we see the following:
7.18 percent may not sound incredible, but it’s not bad at all. Indeed, as Nerd Wallet reports, the average return in the stock market is just 10 percent. So the stock market barely beats principal paydown with none of the other real estate-related advantages!
There are some caveats here. For one, early in a loan, most of the payment goes to interest and then as you progress deeper into the loan, it switches and most of each payment goes to the principal as the following example shows:
Therefore, if you pay off the loan early, the IRR will be less. In addition, if the loan is a 30-year amortization as many are, the IRR will be less too (although the cashflow will be higher).
But remember, this is a 7.18 percent return with no cashflow, no appreciation, no tax benefits and settling to buy at market prices. Add those other benefits in and the rate of return goes up and up.
The power of principal paydown is another reason why it’s not a good idea to sit on the sidelines and wait for a correction just because you think (rightly or wrongly) the market is near its peak. Sure, it’s important to be careful in a hot market like this one. But there are so many advantages to real estate outside of appreciation (principal paydown being one of the most important and least discussed) that you shouldn’t just twiddle your thumbs and wait for a crash that may or may not come at a time no one can really predict.
Andrew Syrios has been investing in real estate for over a decade and is a partner with Stewardship Investments, LLC along with his brother Phillip and father Bill. Stewardship Investments focuses on buy and hold and particularly the BRRRR strategy—buying, rehabbing, and renting out houses and apartments throughout the Kansas City area. Today, Stewardship Investments has over 300 properties and 500 units. He writes for Think Realty, BiggerPockets and The Data Driven Investor.
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