As a hired gun many moons ago I used to do after tax cash flow ‘autopsies’ on investments for attorneys representing either investors or other real estate agents/brokers. I’d produce historic rates of return, almost always expressed as IRR — Internal Rate of Return. I’ve explained IRR, in court, the following way.
It’s that rate of return, which when discounted back to Day 0 equals the original amount invested. (In ‘analyst speak’ that means Net Present Value (NPV) = 0.)
The court accepted the data I was given was correct in those cases, since most of it came from escrow closing statements, CPA’s, management company reports, bank statements and the like — they were relatively reliable numbers.
In one case I was grilled for over 20 minutes about holding periods. It was literally one of the dumbest 20 minutes the judge ever had to endure going by his facial expressions. For me though it was live entertainment.
I won’t bore ya with the details, but the issue of holding periods, at least according to one of the parties, was a big deal. Why? Cuz their decisions were largely based upon the returns for different properties which were compared to each other — so far so good. But then the various holding periods were shown to impact the IRR. Can we have a giant Duh! from the congregation for that one?
True enough, holding periods do indeed impact the return on your investments. The false assumption though in decision making at the front end is in the reliance on a predicted period of time for which you’ll be in the investment property. There are plenty enough factors having an impact on an income property’s return — and should be included in any serious analysis.
For example, interest rate, length of loan amortization, down payment size, tax shelter, and a bunch more, will influence the final after tax return number. The difference though is that with say, interest rate, it’s 6% when escrow closes, and it’ll be 6% a decade later. You know that. Same goes for the equity gained by principal reduction, how much you put down, annual depreciation, and the like.
Back to the courtroom grilling.
The folks who hired me asked me point blank if making decisions consistently based upon specific holding periods, and the ‘predicted’ returns based on said periods was prudent. I answered with a question that made them smile.
What’s the real estate market gonna be like, exactly, over the proposed holding period?
And there’s the rub.
BawldGuy Axiom: Though investors must to an extent buy in to a particular future, using factors to predict that future created outa whole cloth is foolhardy at best, and guaranteed disaster at worst.
Look, after tax cash flow analysis by it’s very nature requires the analyst to make certain assumptions. Future income & expenses for one. Whether or not there’ll be any appreciation, and if so, how much. Those can be at least approached in a manifestly conservative manner. For instance, even though I can empirically demonstrate rents in a region have increased recently, I might opt to do the analysis keeping the scheduled income static over the entire holding period. It’ll give me a feel for performance in a stagnant economic atmosphere.
Holding periods, in my professional opinion, should never be the deciding factor in the acquisition of income property. There are very rare exceptions, but they only prove the rule. Here’s why.
The market tells us when the holding period is over. I’ve been wrong as often as I’ve been right, maybe more — predicting too long or too short. Back in 2001, when asked by a client how long their new purchase should be held, I shrugged and said, “Probably 3-7 years or so.” 13 months later we exchanged that property for them. The crazy appreciation made it an obvious move. Who knew? I didn’t.
Those who bought property in San Diego in the mid-70′s generally felt entitled to obscene value increases in a year or two. Expectations bashed when those who bought in say, summer of 1978 saw the market head toward the planet Insanity with interest rates in the upper teens, and inflation also in double digits. Most of us weren’t able to make a profitably prudent move ’till ’84 or later.
BawldGuy Takeaway: 1) Don’t predict your return based upon your holding period 2) Your crystal ball is as cracked as the next guy’s.
Learn to say, “Oh, look Honey, our holding period was just over 6 years this time.” Holding periods are only an empirical piece of datum when viewed through the rearview mirror.
Wanna talk? I do. Call me at 619 889-7100. Have a good one.
Related posts:
- Purposeful Planning Part Last — When’s Holding Period Over? What Now?
- Buying And Holding — Real Estate Strategy Leading To Unintended Consequences
- So — Which Loan Did You Choose? Real Estate Investors Wanna Know
- How Real Estate Investors Really Get It Done – Attn: Newbies
- Been Holding Income Property Forever? Here’s Some Good News/Bad News
About BawldGuy
Great post, it explained more to me in this short monologue than I’ve ever learned reading real estate investment books. Thanks Jeff!