Making Money

A case study in long term real estate investment

Chief Money Manners! You may be wondering why it has been so long since your Chief Money Man wrote a blog entry? Two simple reasons behind that, although they shouldn’t be an excuse. The first one is that I’ve been launching a global transformation program at my current company. Setting up the team, launching the diagnostics, preparing the change story and launching the program to the 15.000 people in the company across the world. More about that some other time.

That has taken up a fair amount of my time.

Secondly, I decided I needed to take my family on a holiday and so that needed some preparations and then the best part: the execution, which I’m currently full-speed on now, writing to you from a lovely beach, lost in the Indian Ocean.

All this work has not kept your Chief Money Man from working on your favorite topics. I sat down with the great people at Financial Independence Europe for an interview on “how to get promoted at work” and gave them some insight into the world of the Chief Money Man too. Go check it out! They have a great podcast series that is really worth listening regularly to.

 

And I also managed to finish up the below: an article/case study on long term real estate investing.

 

Investing is a long term game, everyone should know that. Of course, you always hear of big short term trades, that earn the trader significant profits. You don’t tend to hear about the losses, as who wants to hear about that? The whole financial system is set up based on the principal of optimism and that things will, by definition, get better in the future, so better to talk about profits.

Short term information about stocks and bond is easy to come by, but I find information about long term investments in other asset classes harder to come by, so I thought I’d share with you a case study of one of my own investments in real estate.

 

The Investment

 

Back in 2003, I was 30 year’s old and was armed with only a small stock portfolio. I had taken time off to write a novel and was just recently back onto the career ladder. I knew that my next investment needed to be in real estate as I couldn’t think of an easier way to perform a leveraged investment (using debt to fund the purchase of an asset).

I wasn’t yet able to buy the apartment I wanted to live in, a two or three bedroom apartment, and could only afford a one bedroom. So instead of saving more, and watching the property market continue to grow, I thought I’d start out as an investor.

I poured over the various arrondissements in Paris, looking at real estate rental yields, the number of apartments available for rent and how long they stayed available on line before being snapped up (which was a good measure of the vitality of the market) and doing research on recent sales to get a good understanding of what the market was using to value the assets.

 

After 3 months, I finally settled on the Marais area and the part of the Marais up in the 3rd arrondissement, near the market street of Rue de Bretagne, which is very lively and animated. I had concluded that any rental needed to be near a lively area as most of my target market would be coming to Paris for an average of 6-12 months.

My target market was expats coming to live in Paris – not students – but young professionals who needed a high quality furnished rental to immerse themselves in the Paris lifestyle and use it as a lock up and go when they wanted to travel on their weekends to the various corners of Europe.

 

I lined up several apartment visits on one day with an agent I had gotten to know and on that single day I chose and bought a one bedroom apartment on a great little street right bang in the middle of my target search zone.

 

It was a 40 square meter (approx. 400 square feet) one-bedroom apartment that cost €200.000.

I intended to use 100% leverage to purchase the asset.

 

The earnings of the purchaser

 

Back in 2003 I was earning €60.000/year. I was pulling in approximately €4.000 pre-tax and €3.000 per month after tax. The mortgage repayment represented a monthly fixed outgoing of €1500 or 50% of my take home income. Clearly the bank would never have allowed me to buy the apartment as my pre-tax mortgage to income percentage was close to 40% whereas the banks target 30% as the ideal ratio.

The only way to purchase the apartment would have been to put down a hefty down-payment to bring down the mortgage payments or to increase my revenue.

I decided on the latter.

 

The business model

 

I had done my research on rental yields at the time and knew that if I upgraded the apartment, by putting in a new kitchen, repainting the place, putting in new wooden floors and furnishing it to a high quality, I could ask for up to €1.250 in monthly rentals. That meant, as long as the place was rented, I would only have an “effort” of 250 euros to pay each month, being the difference between my rental income and the mortgage.

The rental yield (total annual rental income divided by the cost of the apartment) was a whopping 7.5%, almost on par with the average historical stock market returns.

Real estate was increasing at an average of 6-8% a year at the time, so my annual return, on paper, was staggering. I assumed at the time, to work out my potential return, that real estate would only grow about 3-5% per year over the next decade. With the rental I was thus hoping for an average 10% annual return on my money.

 

The costs of purchasing and running the asset

 

However, the rental yield, based on only the above parameters was a bit deceiving.

Why?

Well, firstly, purchase fees represented an additional 6% or €12.000 of the cost to purchase.

Secondly, I needed to invest approximately €40.000 in renovation costs and furniture.

 

That meant that the total outlay was € 252.000 representing the total of the €200.000 purchase price, the €12.000 of purchase fees and the €40.000 of renovation and furnishing costs.

 

These extra costs brought my rental yield down to just under 6%, so still impressive by Paris standards.

 

The last element I needed to factor in was building management and maintenance costs which represented €90/month. I also factored in about €1.500 of annual upkeep costs, which meant my rental yield came down to : 1.250-90-(1.500/12) = 1.035 per month net rental, and so an annual rental yield of  just under 5%.

 

The further elements I factored in was a fairly strong increase in rental rates, given the growing demand for the region, but this was just a hypothesis at the time. I also estimated that the property market may well double in the next 10-15 years. I was hoping for the lower end of the range.

 

What happened next? The overall return

 

Rental prices in the region did indeed grow up until 2008 and the start of the Worldwide and European financial crisis. For the next 8 years, rental rates were either stable or went down. I had some very stable tenants, so I was able to keep my rental largely flat.

Today the rental is 1.600 euros a month.

If we look at the average annual rental increase over the last 15 years, we can quickly calculate an average of 1.7%, which has been slightly better than inflation.

 

Overall, the €1.500/year in upkeep costs turned out to be pretty close to reality, and today equates to a total spend of approximately €25.000 over 15 years.

 

I’ve had to finance approximately €15.000 of mortgage costs (representing the difference between the rentals and mortgage payments) over the last 15 years and about €16.000 in building management costs. The mortgage is now fully paid off.

 

 

My total outgoings were as follows:

 

  • Purchase costs €12.000
  • Renovation costs €40.000
  • Upkeep costs €25.000
  • Mortgage costs above rental €15.000
  • Building management costs €16.000

 

Total €108.000 investment spread over 15 years or €7.200/year or €600/month.

 

The apartment growth has been 2.5 times and currently the apartment is worth around €515.000.

 

When I look at my total return, I would take my outgoings of €108.000 and compare that to the current worth of the apartment of €515.000 and annualizing the return to the average over 15 years equates to ~11% per year.

 

Overall take-aways

 

An 11% annual return over 15 years is pretty good by any standards and slightly above my target when I started out.

The return was very passive as I only had a handful of tenants who were all pretty self-sufficient and so if I spent an hour a month on the apartment, that would be vastly over-exaggerating my time spent.

 

The hardest part of the investment was the preparatory work before I actually bought the apartment. The second hardest part was sticking with it and not being tempted to sell.

Real estate investments are long term, by definition, and so you need to hold them long term to get the most out of them. I wanted to sell on numerous occasions over the last 15 years: to help finance my primary residence purchase, to diversify out of real estate, etc etc, but each time I was able to talk myself out of it by coming back to the original investment premise.

Now after 15 years, I have tenant who is staying for another 3 years, so I’ll end of holding it for the next 3 years and then in all likelihood, I’ll sell it. Currently it is bringing in net passive income of around €18.000/year and the asset growth is currently representing another €15-18.000/year.

 

Of course, this is just one case study in a successful real estate investment and not all real estate investments are successful.

 

The difference between a good and bad real estate investment is usually found in the preparatory ground work.

 

I spend several months pouring over available market data of several locations until I was able to target something I really believed in and where the investment decision was supported by reliable historical data.

I wasn’t greedy in the approach and I made sure the risk was measurable and manageable. These are all key elements to make sure you tick off when making a solid long term investment.

 

Planning is 80% of the investment.

 

Good luck with your real estate investment and as ever, if you have some specific questions, feel free to leave a comment below.

 

The CFO

 

 

 

 

 

 

3 Comments

  • Sport of Money

    I grew up in NYC and live in NYC but visited Paris while in college. I went back to Paris a few years after graduating from college and really enjoyed the city. Shortly after my second visit, I thought about buying a small apartment there and thought pricing was fair compared to other global cities. I, ultimately, did not pull the trigger because it was hard for me to manage a property so far away.

    I currently own a portfolio of rental properties. I take a forever view each time I purchased an investment property. Transaction costs make buying an investment property and holding for a short while not economically attractive. Over a long period of time, real estate is a great builder of wealth.

    That is why I am a big fan of real estate being a cornerstone of any investment portfolio.

  • The CFO

    In Europe the banks don’t tend to look at the loan amount but rather your ability to afford the monthly payments. As the vast majority of loans are fixed rate loans over the entire term, the focus is clearly on affordability so 100% loans are commonplace.

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