Loan Terms — Appreciaton — Capital Growth Is What Matters Most

Posted @ 12:51 am - Filed under 1031 Exchanges, Real Estate Investing, Neg-Am Loans, Financing, Buying Income Property, Capital Growth

At this very moment, somewhere in the country, there’s an investor making a decision between two or more properties, based almost, if not entirely upon what they think the appreciation rate will be. If all other factors are equal, this isn’t a problem usually.

However, if the financing is fixed rate in one area, and neg/am in another — well, you have much more to consider. Things aren’t necessarily how they seem — even if you’ve done all the numbers to your satisfaction and checked ‘em thrice, you could be making a common mistake.

Neg/am loans are part of an investor’s tool bag. They’re not the best thing since sliced bread, nor are they Satan’s loans. They’re to be used when the circumstances are right, and that tool is called for. In growth areas like San Diego for example, when prices were going up like a NASA launch, they were the perfect way to afford twice the property.

Twice the property multiplied by double digit appreciation rates = a pretty cool upward modification of yer net worth.

Those days are over for awhile — and nobody knows for how long. Betting on high appreciation rates for the foreseeable future is, to use a real estate technical term — stoopid.

Back to choosing between two properties in two areas with different financing.

Both properties will be acquired using 10% down payments — are in growth regions — with great locations. Operating expenses of 35% will be used for each.

Note: This is an illustration. You surely won’t infer from it I’m predicting there will be regions appreciating at 10% yearly for the next five consecutive years. I believe that’s plausible — just like it’s plausible the colored eggs my kids used to find on Easter, were hidden by a big bunny.

Choice #1 — Appreciation: 10% annually for the next five years. Price: $225,000 Rent: $1,450 monthly

Choice #2 — Appreciaton: 5% annually for the next five eyars. Price: $225,000
Rent: $2,200 monthly.

#1 requires a much lower loan payment, because the rent just won’t cut it with 10% down — if our investor insists on putting 10% down. He either uses a neg/am loan, or has some pretty significant negative cash flow, or walks away. His net operating income just won’t service a fixed market interest rate.

#2 can support a 7% interest only loan, (including added mortgage insurance) with its net operating income. It will cash flow roughly $100 monthly, or as I tell my clients — let’s just call it a break even and call it a day.

Neg/am minimum loan payments are based on what I’ve always called their cartoon rate. That rate these days, for an investor non-owner occupied property, will run around 2-4%. However, the real or indexed rate, the rate you’re really paying, is 7.75%.

Let’s use one of the currently more popular loans. Cartoon rate = 2.375% Real (indexed) rate = 7.75%.

That’s a 5.375% spread. What does that mean to the investor you ask? In dollars, it means the first 12 months will result in the following.

Remember, the price was $225,000 with a 90% loan — $202,500.

Now take the difference between the cartoon rate and the indexed rate (5.375%) and multiply it by the original loan amount. #1 will have an increased loan balance of roughly $10,900 after the first year. Based on the purchase price of $225,000 — the appreciation rate that year needed to be 5% for the investor to be ahead by less than $500.

In other words, his capital growth rate doesn’t even begin, until his investment property appreciates –above the 5% rate. That’s fine if, for whatever reason, you believe the property will rise in value sufficiently. There are many areas of the country, currently moribund, that will resume their growth as their particular region emerges from this correction.

Neg/am loans will still be of value in those regions — but only if the investor believes in its future growth.

In 1996, San Diego had been sickly for almost five full years. It was, literally the worst stretch I’d seen in my career, hands down. Still is by a long shot. The current correction in comparison? A 1st grader’s birthday party at Chuck E. Cheese. Really.

I had faith in this region’s fundamentals. Investors, in my judgment, could make use of neg/am loans then, because the fundamentals said supply/demand was on our side, along with the job picture, and several other factors. This opinion turned out to be correct.

I don’t think that about San Diego any longer, nor do I expect to ever again.

That said, there are many regions for which I harbor expectations of growth, just as I did a decade ago for San Diego.

Now #2.

It breaks even or trickles a little cash flow. The loan is interest only, so nothing’s happening to the loan balance — either way. (Take deep breaths Chris, it’ll all come out well in the end.)

It appreciates at half the rate of #1. Yet, the capital growth rate of our investor is 50% the first year. After five years, his property value would be about $287,000 or so. If they decided to execute a tax deferred (1031) exchange at that point, their net proceeds would be just less than $62,000.

Soooooo, in five years, if the investor chose #2, his capital growth rate for the five year holding period would have been, give or take, over 22% annually — at only a 5% yearly appreciation. This doesn’t count cash flow or tax savings through depreciation, which of course moves that figure up.

All this to demonstrate this: Investors chasing appreciation, need to seriously weigh carefully whether the neg/am gamble is worth it. Time and money must always remain central to any investment analysis. In order to choose #1 I would have to believe the appreciation figures, over the long haul, would be impressive. Of course, growth regions aren’t known as growth regions because they have poor fundamentals, right?

You better hope so.

When, back in the day, I used to teach cash flow analysis, and all that goes with it, students would ask me how I decided which property was better over time. That’s always been easier than you might imagine.

Our policy is simple: If the analysis is fairly even, pick the safest. How hard was that?

If the decision isn’t which one, but whether the client should do something, or nothing, we view it this way: If the analysis shows us the move will yield only marginally beneficial results, we tell them to pass. The policy is to give a go signal only if it’s truly a no-brainer.

Marginal moves just don’t make sense.

As enticing as some investments can be, there are times when solid analysis shows them to be mediocre — or marginal. Learning to discern what area to choose, isn’t always about the highest appreciation rate, or the lowest loan payment.

If your agenda is growth, paying attention to your capital growth rate is numero uno on any list you wanna make. I realize this sounds the same as saying grass is green, and the sky is blue. The difference is, you don’t confuse grass and sky.

Investors seem to think, at least sometimes, that appreciation and capital growth are synonymous.

Big mistake. Appreciation does not equal capital growth — contrary to popular opinion.

Investors paying attention to appreciation to the detriment of capital growth — are destined to learn what really matters.

It’s a lesson you don’t want to learn the hard way.

This entry was posted on Saturday, October 27th, 2007 at 12:51 am and is filed under 1031 Exchanges, Real Estate Investing, Neg-Am Loans, Financing, Buying Income Property, Capital Growth. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.