A typical scenario is as follows. It is boldly claimed that while yields on properties averaged, say, 6 percent in a given year, the average yields on stocks averaged, say, 19 percent, so why would you be bothered with all the hassles of real estate investing when you can get a better return from something that requires much less involvement?
On the face of it this seems like a sensible argument, and I know from the countless people who have told me so in per- son, by phone, fax, e-mail, or letter, that such advice was an ongoing reason why they did not get into the real estate game at a much earlier stage.
To understand why such a comparison is nonsense, we have to, once again, compare apples with apples.
When you invest $100,000 cash in the bank, and you receive $6,000 per annum in interest, then the yield is simply 6 percent. (The true yield will vary somewhat depending on whether the interest is paid monthly, quarterly, annually, or even weekly, daily, or continuously, and whether it is paid in arrears or in ad- vance. However, in all cases it will be close to 6 percent, so let us just generalize and agree that the yield is 6 percent.)
Similarly, when you buy a property for $100,000 and you re- ceive $6,000 per annum in rent, then the yield is, by definition, 6 percent. (Again, technically there will be a difference depend- ing on whether the rent is paid weekly, biweekly, monthly, quar- terly, or annually, but let’s again generalize and agree that the yield is 6 percent.)
On the basis of yield alone, it would be fair to say that both investments returned the same amount.
Many advisors who are property-averse are quick to quote the relatively low yields of real estate, and go on to steer their clients into other investment arenas.
However, is that where the comparisons should end? By now you should be jumping out of your skin saying, “What about leverage?”
CONSPIRACYTHEORY 23
Whereas the $100,000 deposit in the bank required $100,000 in cash, the $100,000 property could be bought, using our 90 percent loan-to-value ratio, using only $10,000 cash. So the rental return of $6,000 should be considered relative to the cash input, not the arbitrary purchase price.
Of course, if we do that, then we have to take the interest payments into account. If the interest rate is, say, 5 percent, then we would be paying $4,500 in interest, and we would be left with $1,500 per annum ($6,000 in rent collected minus the $4,500 mortgage interest payments). Done that way, the return would be 15 percent ($1,500 divided by the $10,000 cash input). As the owner of the property you also have property taxes, insurance, maintenance, pest control, management fees, and a variety of other expenses that have to be taken into account.
Then again, on the plus side, for taxation purposes, you can depreciate the building, usually at around 2.5 percent to 4 per- cent depending on where you live. Furthermore, the contents of the house—the chattels, or fixtures, or fittings, whatever you want to collectively call the lamp shades, curtains, drapes, ver- tical blinds, extractor fan, dishwasher, stove, fridge, washing machine, dryer, floor coverings, irrigation system, wiring, plumbing, and so on—can usually be depreciated at a much higher rate, typically around 20 percent to 30 percent. Note that depreciation means you can reduce your income for taxa- tion purposes without it costing you even one cent out of your pocket of the amount depreciated.
Finally, when you deposit $100,000 in the bank for a year, then all you expect to get out of it is the interest. If you know what the interest rate is going to be, then you also know what the return on your investment will have been: It is only the $6,000 of interest earned, divided by the amount of the invest- ment. This is really stating the obvious!
Conversely, when you buy a $100,000 property, at the end of the year its value may have changed. To know what return 24 REAL ESTATE RICHES
you have had on your investment, you will not only need to know all the cash flows into and out of the property (such as rent, maintenance, mortgage interest, and tax benefits), but you will also need to know how much the property will have changed in value during the year.
You may have noticed a subtle issue with the two situations above. When comparing the increases in asset values, the USA Today article compared the average rise in property values with the average returns from CDs and other cash investments. Other charts compare the cash flow yields of equity invest- ments with the cash flow yields of properties. Apart from stocks, most financial instruments only enjoy either an in- come, or a capital growth, whereas property enjoys both.
Clearly, working out the true return on a property invest- ment is much more complex than simply declaring the yield on a bank deposit. Later on I will explain how you can quickly and easily work out the true return on a property, and I promise you, this will be a real eye-opener, one that will make you say something like: “Why did no one ever explain it this way to me before?”
By buying into the notion that it is fair to directly compare property yields with the yields on other assets, or increases in property values with the increases in value of other assets, you may be missing out on some of the most lucrative investment propositions out there. Always compare apples with apples!
CONSPIRACYTHEORY 25