I’ve been investing since I was 14 years old. Somehow that’s the last 18 years (how can I be 32?). During that time, I’ve always had a job and saved, read hundreds of books on investing, paid attention to stock market news, earned a degree in finance, and more. TL;DR: I’ve spent a lot of time, energy, and money in the stock market.
The amount of money I’ve made investing in stocks (through two full blown bull markets) in that time pales in comparison to the amount I’ve made from rental property. Of course, that’s not because I’m a genius real estate investor. That’s largely down to timing and luck, but also the inherent leverage of investing in rental property.
To illustrate this concept and show how some of the principles I’ve followed in real estate investing would have improved my stock market returns, I’ll compare two investments I made around the same time. In December 2014 I bought a 600 square foot condo with the intention of renting it out after living in it for at least a year. In February 2016 I bought 100 shares of Annaly Capital Management (ONLY -4.79%), a mortgage REIT that often has a dividend yield in excess of 10%. We start with Annaly.
Annaly is a mortgage REIT (Real Estate Investment Trust). It borrows money and invests it in mortgage-backed securities, which are usually guaranteed by the government. It makes money on the spread between the two interest rates. As long as borrowing rates stay low and the mortgages it buys aren’t prepaid, it issues cash that it distributes to shareholders.
I bought the REIT as a source of income. It had a high dividend yield and low volatility, so I sold covered calls on the position to increase the dividend yield. Here’s a table showing all the transactions I’ve had on Annaly since that first purchase:
|transaction||sum of the amount|
Over the years, I’ve made $566 in dividend income and $204 in option premium income from Annaly. The stock has been recalled by me several times, and I usually repurchased it soon after, except for a two-year period when I didn’t own it (and missed some good dividends). It’s certainly possible that I could have made more money if I had given up the covered call strategy and just held the stock the whole time. Here’s Annaly’s total return since February 2016.
Rental of real estate
I bought the condo in December 2014 for $90,000 with a down payment of about $5,000 (note that I’m only using round numbers for this example to make it easier). I lived in what is required to buy as a residence for over a year and then started renting it out.
Since I started renting the property, it has generated just over $12,000 in cash flow. My total investment is around $24,000 when you include the down payment and any mortgage payments I made prior to renting. That’s a 50% return in about five years. But there is more to the return than that.
The real estate market in Utah, where I live, has become a gangster in the last five years. According to an appraisal I received in 2021, the condo is now worth around $229,000. That’s good for 154% capital appreciation, or 14.3% per year. But wait, there’s more!
I’ve been paying off the mortgage the whole time. I personally paid for the first few years, and that amount is included in the total investment of $24,000, but since the rental began, the tenant has actually made those mortgage payments. Currently, the property’s total debt is $72,000. That means there is $157,000 in equity.
If you add everything up. I invested $24,000, received $12,000 in cash flow and $157,000 in equity. That means my $24,000 investment turned into $169,000. That’s a 604% return, annualized at 48%. Note that if I sold the property and had an average tax rate of about 20% on the sale, the taxes would reduce that annual return to 39%.
Of course, if 48% annual returns on real estate investing were in any way common, no one would invest in anything else. There were a few factors that went in my favor that don’t always (or even often) happen. Let’s go through them:
- capital appreciation: It is not normal for the market price of a condominium to increase by 14% per year. A combination of low interest rates, population growth in Utah, and limited supply contributed to this price change.
- Interest charges: Interest helped me in two ways. They helped raise the price and also reduced my mortgage payment. This means I was able to keep more cash flow each month and more of my payment was used to reduce the principal balance.
- Other expenses: Interest wasn’t my only relatively minor expense. During the rental period I replaced the air conditioning, the washing machine and the garage door. There were no other major expenses. For a 40-year-old condominium, I could have had a lot more problems and probably more vacancies.
Aside from being lucky with a few rental factors, Annaly wasn’t a good investment. Even if I hadn’t traded the position with options, a 39% total return over six years is big fat meh.
We’ll finish with a modified scenario that’s a little more duplicable. Let’s say you buy a $90,000 rental condo that receives $10,000 in cash flow and has a market price of $150,000 after five years. Also, let’s say instead of investing in Annaly, invest in prologue (PLD -1.04%)an industrial REIT that has outperformed.
The Prologis total return would be 270% and peaked at over 300%.
The $24,000 investment in the condo turned into $10,000 cash flow and $78,000 equity ($150,000 – $72,000) for a total of $88,000. That’s a total return of just under 270%.
Both strategies can be very profitable – as long as you stick to them. Switching in and out of my Annaly position likely halved the total amount of dividends I earned during that period. For Prologis, deducting the dividends would reduce the yield to 210%.
Now an investor can make a pretty nice return by selling the condo. But what then? You’d have to pay taxes on the capital gains, give up months of rent, and then put the proceeds into a new investment. With stocks and rental properties, it usually makes sense to hold for the long term.