Comparing ‘Boom Time’ Geared Investments With Non-Geared Cashflow Investments

October 4, 2011

When holding investments, one of the most important pieces of information to have is to know the true value of the investment. Typically this means the value of the investment as compared to other similar investments, so you can sleep well knowing your holdings constitute good value, especially in the current economic environment.

An example could be the ‘8% rule of thumb’, which held for many years for geared residential investments.

In an environment where typical gearing is 80%, and interest rates 5% – an 8% yield was often seen, at least in a positive capital growth scenario, as a minimum level to interest investors. Looking at this return, a $100,000 investment with 8% yield would give $8000 per annum income. Add say $5000 a year capital growth, then you have $13,000 income, minus interest of $6,400 = $6,600 per annum against $20,000 investment, a rough return of 33%.

But what happens in an environment when banks retreat from real estate? And when capital growth cannot be taken for granted? Then to obtain the same true value, your investment should be getting the same rough return. Let us look at 2 examples of cash purchases.

1. A foreclosed villa in Florida. Rent $12,000 a year, value in 2006 – $200,000, sold now for $100,000. Seems a good deal huh? No. Not at all. As a cash purchase, the rough gross return is only 12%. In a state with one of the highest number of houses in foreclosure in the country, ‘capital growth’ simply isn’t going to happen. And even if miraculously there was 10% capital growth then the return would only be 12+10=24%. Therefor even in a best-case scenario, compared to the first investment, this house is bad value.

2. A cheap cash-flow duplex rental property in Western New York. Rent $12,000 a year ($500 a unit per month) costing $30,000. Needs $7,000 renovation. $12,000/$37,000 = with no capital growth, it gives just below the same 33% return as the original house.

In other words, as example 2 shows, in a non-gearing and non-capital growth environment, you’re going to need a gross yield of 33% to ensure your investment is similar value to the 8% yielding ‘boom time’ investment.

Author Alan W. Findlay is a Partner in Abbotsinch Capital with more than 15 years of experience in real estate investment.

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