First, let’s talk capital growth. We should all be on the same page when it comes to our understanding of exactly what it means in real terms. There’s nothing sophisticated about it whatsoever. It’s simply the affect appreciation has on the actual capital invested into a given property — which for our purposes will always mean the dollar amount the real estate investor had to bring in to close the transaction.
So why do I tell folks to quell their irrational infatuation with the appreciation of their properties? Let me to go all Socratic on ya here.
Did you write a check for the amount of the purchase price? If not, how does the percentage of appreciation translate to a figure accurately representing the percentage by which your capital grew? Is it possible for one investor to enjoy a higher appreciation rate than his buddy, but have a lower capital growth rate? Does any kind of growth not ultimately ending up in your bank account matter a whit to you? Yeah, me neither.
Here’s the fifth grade math.
You buy a $250,000 income property with 20% down and 2.5% total net closing costs after all prorations. This results in a total capital investment of $56,250. Your buddy at work buys a similar property in another region for the same price and costs but with 30% down. Your property appreciates 4% the first year, while your friend’s rises by 5% — a rate of increase 25% higher than yours.
So to what property’s capital growth rate would the typical new investor be drawn? They’d prefer the highest appreciation rate — they almost always do.
Your buddy, ‘Joe’ ends up with a handsome growth rate of almost 15.4%, while you end up with growth of just over 17.75%. To review, even though Joe was the happy recipient of a 25% higher relative appreciation rate, 5 vs 4, your capital outgrew his by over 13%. ‘Wait just a doggone minute here’, says Joe. ‘I made $12,500 while he only made $10,000 in real dollars.’ Excellent observation — irrelevant, but good catch. Why is it irrelevant?
Let’s expand the comparison here.
Let’s say they both had $170,000 to invest. Joe acquired two. You bought three, ‘cuz Joe was putting an additional $25,000 in down payment per property with the same amount of initial capital. Since we’re now workin’ with more or less equal amounts invested ($169,000 for you, and $163,000 for Joe.), let’s revisit the comparative growth rates, using the same rates of appreciation.
Your relative capital growth rates haven’t changed from the original property to property comparison. However, you’ve now earned more growth in terms of percentage and dead presidents. And as we all know, it’s ultimately the quantity of dead presidents that separate those who retire OK, vs those who retire Woo Hoo!! Let’s do one more thing with these numbers. How would they look after five years?
Five years later Joe’s capital has grown from $163,000 to $301,000. Meanwhile, your capital will have grown to $331,500 from our originally invested amount of $169,000. The gap widens into a seemingly bottomless chasm in 15-20 years. Also, there will be a time when you get 9% appreciation on top of better leverage, while Joe gets 2% appreciation on his inferior leverage. When that happens, you won’t be able to see Joe in your rear view mirror any more.
BawldGuy Takeaway: Appreciation in the value of your real estate investments is solid ground for braggin’ rights, but you bank capital growth. Both leverage, and the value of the property acquired impact capital growth big time. Duh — Bottom line?
Appreciation is the shiny chrome, while capital growth is the engine driving you to retirement. Don’t make the mistake of being distracted by the cool lookin’ chrome.
Give me a holler and we’ll figure out what direction is right for your circumstances. Understanding the fundamental principles of real estate investing is more than a big deal when it comes to creating your retirement. It’s everything. Have a good one.
Related posts:
- Growing Real Estate Investment Capital With Little Or No Appreciation
- Why Appreciation Is Most Misunderstood Real Estate Investment Concept
- Real Estate Investors: Keeping Your Eye On The Ball
- As A Real Estate Investor Ya Gotta Pick — Capital Growth or Cash Flow
- Real Estate Investors Movin’ Capital From California To Texas
About BawldGuy
That sound you hear is the sound of exploding brains.