As a Property Ages, so Does Its Return
The option of simple and cheap mortgage financing raises the attractiveness of investment properties. The use of credit (leverage) increases the return on funds invested in the property. Advantageous mortgages are among the reasons why investments in "bricks" enjoy great popularity in Slovakia. However, the return on a leveraged investment property falls sharply as the principal of the loan decreases.
Šimon Pekar | Investment academy | 17. August 2022
In the previous blog on property prices, we reflected on a consideration that bothers our clients more and more often: Is this the ideal time to sell an investment property at the peak, moving the funds into financial assets, primarily stocks, which have experienced sharp declines this year?
Today, we further develop this consideration with a fact overlooked by most mortgage real estate investors. Albeit mortgages attractively increase the net return on resources invested in real estate, it occurs only up to a certain point. The leverage effect fades over time as the loan’s principal decreases.
Please note: All data relating to the historical development of Finax portfolios were created based on backtesting. We have described the method of modeling historical performance in another article. Past performance is no guarantee of future returns, and your investment may result in a loss as well. Learn what risks you take when investing.
What Is the Long-Term Return of Real Estate?
Real estate generally yields a lower long-term return than stocks. In Slovakia, many will intuitively challenge this statement. Such an opinion stems from several reasons.
Firstly, our country has been transforming over the past three decades, turning from a centrally controlled economy without significant private ownership to a market economy with tenacious property rights.
At the same time, the purchasing power of the population has grown rapidly. Housing construction slowed down after the collapse of the previous regime. The changeover to the single currency, the euro, brought extremely cheap external financing for house purchases. Strong bank competition also led to unprecedentedly low interest rates.
Lastly, the decent growth in property prices owes to their extreme popularity among Slovaks. Most people, when assessing the profitability of investing in real estate, forget to factor in all the costs and taxes associated with it. The buildings‘ prices themselves approach zero over time, as each property has a limited lifetime. Only land retains value.
For an objective assessment of these investments, we need to look to countries where the market economy and the free real estate market have a longer history. Those reveal that the average historical return on real estate is around 5% per year, while equities yield over 9% yearly.
We discussed the long-term comparison of real estate investing to a diversified global stock portfolio in our recently updated blog Real estate is thought to be the best long-term investment. Is it?
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One of its conclusions was that the profitability of a property investment depends largely on how you finance the purchase. When buying in cash, a real estate investment does not pay off, as the stock market offers higher long-term returns and is also less demanding to maintain. However, when buying a property on a low interest rate mortgage, real estate becomes very competitive.
A Mortgage Boosts a Real Estate Investment’s Return
Financiers use the term leverage to describe a purchase of an asset with borrowed money. In physics, a longer lever increases the applied force. Finance works similarly, buying on a loan increases the potential return (but also the potential loss).
This is because you don't have to save up a large amount. Typically, you can acquire the entire property after paying just 20% of the purchase price, earning returns tied to 100% of its value.
A simple example of the appreciation of a mortgage-funded property:
You bought a property for €200,000, of which €40,000 is your money and €160,000 has been lent to you by a bank via a mortgage. Over the next year, the price of the property has risen by 5% to €210,000. A price increase of €10,000 against the €40,000 you invested represents a return of 25%.
The potential rent should normally be added to the final return, but you have to subtract the costs of running the property, the interest on the loan, the taxes and levies paid, the maintenance costs, and the time you have to devote to this investment.
Anyway, even after subtracting these, the return on a leveraged investment property will remain very appealing in the first year, which is the essence of the attractiveness of investing in real estate using a mortgage.
Even in the following years, the collected rent will help you fund loan repayments, enabling you to later claim the full proceeds from the sale of the appreciated property. Relative to the original deposit, this can be a decent percentage of profit.
Based on this conclusion, you could argue that with an efficiently used mortgage, even a 4-5% increase in the property price is enough to beat the stock market in returns. However, the power of mortgage financing fully manifests during the initial years of the investment and fades later on.
Diminishing Returns as the Property (Mortgage) Ages
In general, the stronger the leverage (the higher the share of the mortgage on the property’s price), the more it multiplies the return you would have earned even without leverage due to the increase in the property’s price.
The strength of the leverage depends on the ratio of the outstanding principal of the loan to the market price of the property, called the LTV (loan-to-value) ratio. The higher the LTV, the stronger the leverage.
Note that the LTV does not remain constant throughout an investment. On the one hand, as you gradually pay down the principal, the outstanding value of the loan decreases. Alongside this, the price of the property (your investment) increases. Thus, a gradually smaller share of the investment is covered by the remaining debt.
The LTV ratio, therefore, decreases over the investment horizon. Along with it, leverage naturally declines over time, reducing our returns.
Therefore, an investment property usually yields the highest return right at the start of the horizon. The leverage is extremely high during the initial years, allowing returns to reach tens of percent. In the following years, however, the potential gains drop significantly, gradually falling below other opportunities.
Let's look at the numbers.
The table below depicts the aforementioned parameters in a few selected years. In the calculations, we assume the purchase of an investment property with an initial value of €200,000.
It is financed by a mortgage with an interest rate of 3% p.a., while 20% of the price was paid from our own resources (€40,000). Thus, the loan-to-value ratio (LTV) is 80% at the beginning.
Furthermore, we assume a 4% long-term annual growth in Slovak real estate prices. This estimate is based on a study that analyzed data on the real estate market in the UK from 1901-1970. This figure already includes rental income, which tends to be negligible due to operating costs and nowadays also higher debt repayments.
You would have earned a solid 20% in the first year. However, the return would drop by almost 4 percentage points right the year after, and by the sixth year, your investment would be earning less than the average stock market return. In later years, profits would be even lower.
For a comparison with the stock market over the entire investment horizon, see the chart below. We attribute an average long-term annual return of 9% to the stock market.
Although real estate outperforms the stock market due to leverage during the initial five years, their returns turn similar by year 6, earning significantly less later on.
The Cost (Interest) of Leverage also Affects Its Strength
When assessing the impact of leverage on real estate returns, the interest rate of the mortgage should not be neglected. Naturally, the lower the price of the loan, the higher the positive leverage effect.
For example, if you are paying an interest rate of 1% per year on your mortgage, with 80% of the property’s price covered by the loan, you can subtract roughly 0.8 percentage points per annum from the appreciation of the property’s total value.
However, with an annual interest rate of 5%, the cost of the loan will reduce your property appreciation by almost 4 percentage points in the first year, which will be reflected in the net return on your own funds invested at purchase.
Therefore, when assessing the profitability of an investment property, take into account the current rising interest rates on mortgages. Alongside the seeming peak in property prices and potentially falling leverage, this factor further reduces the current attractiveness of real estate.
What to Do with Older Mortgage-Funded Properties?
If you own a property older than 5 years, leverage won’t save your returns if the price growth slows down. Hence, it is worth considering other ways to earn more.
There are two ways to achieve this:
- Permanently increase your mortgage principal by refinancing it against the appreciated (current) property price and investing the money you earn in other assets to boost leverage.
- The second is to sell the older property and invest the proceeds in index ETFs. This will provide you with a passive return higher that is higher than the yield on real estate (provided you have invested for at least 5 years).
A Generous Discount for Transferring a Real-Estate Investment to Finax
If basic investment math has led you to consider selling investment properties at the current peak, don't forget about the attractive discount Finax is offering for investment transfers. We have expanded the list of assets we accept for the transfer discount to include real estate.
If you document the sale of a property and choose to invest the proceeds via Finax, we will manage 50% of the value of the transferred investment free of charge for 2 years.
More information on the investment transfer discount.