Monday, April 5, 2010

Comparing ‘apples and oranges’ - The real thing

 Please note mistake in table: Berkshire-Hathaway's performance of 9.46% was from 1996 until today - NOT since inception.

Well, here is the real comparison (as I see it) between real estate investments and other investments. All data is expressed as compounded rate of return. The rate based on the compound interest equation:
FV=PV x (1+rate)^ yr
FV= Future Value; PV= Present Value; rate= Compounded annual rate of return; yr= investment time in years.

Numbers are derived from the extensive stock market analysis by Jeremy Siegel (The Future for Investors, published in 2005). There is also comparison data based on the performance of Warren Buffett’s Berkshire Hathaway and John Templeton’s Growth Fund from inception in 1954 to today.

Jeremy Siegel compared long term (200 years) stock market performance with that of various asset classes and the second best asset class was U.S. Government Bonds which had over the last 80 years an average nominal annual return of 7.9%. All these rates include inflation

In a REIN forum post by Thomas Beyer commenting on the first posting titled “Comparing ‘apples and oranges’” stated that real estate returns comprise two components:
1. Return on Time (or labor) investment
2. Return on Capital investment

The Return on Time Investment is basically work compensation, while Return on Capital Investment represents the rent paid for the use of capital. We consider the latter the true return on investment as it represents money working for you rather than you working for money.

A real estate investor can buy a property, rent it out and manage the rental operation, use leverage (a mortgage) to enhance his/her profits and after a number of years the property can be sold (hopefully) at a profit. This is the most basic form of real estate investing (apart from owning your own residence). In this scenario, profits represent a combined return on work and on capital.

The same real estate investor (Finder) may use a partner to provide the capital and financing portion of the transaction. The Finder of such a Real Estate Joint Venture (JV) provides the expertise in locating an appropriate property, finds passive investing partners, arranges for the acquisition, and organizes the financing. The Finder also manages of the property and is responsible for the accounting. In return, the profits of the JV are split on a 50/50 basis.

The question arises as to what the returns of such a JV operation are and how they compare with the return of the other investment classes? The author ran two JV scenarios using a typical Calgary two-bedroom apartment bought at a low capitalization rate (2.6%) and a second property more typical for an average Canadian property at a cap rate of 6.5%. Calgary is known for its low cap rates when compared with the average Canadian property, but the rate of appreciation is typically higher to offset this. In Calgary over the last 33 years, the property appreciation was 8.1% per year, while the average Canadian property appreciated at a rate of 6.4%.

The Basic Real Estate Scenario, run over a 5 year period, with an initial Loan-to-Value ratio of 75% and a mortgage rate of 2.25% resulted in a 23% return for the Calgary property and 25% for the average Canadian property. It should be noted that these are total returns combining both return on time and capital invested.

For the Finder of a 50/50 JV, the return on capital is infinite, since no capital was provided. For the passive investor, the annual compound rate return was 14% in Calgary and 15% for the average Canadian Property. This compares to an annual S&P500 return of 11.9% for a stock market investor.

These numbers show why it is so difficult for starting JV investors to attract capital from passive investors other than friends and immediate family. Finder investors with an extensive successful and consistent track record are more likely to attract investment capital.

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