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Why You Should Be Excited About Passive Equity

One of the fundamental differences between buying a home, and investing in real estate, is who pays the mortgage. In Japan because interest rates are low, the differential between a residential mortgage and an investment mortgage may only be 1%. Given that the residential mortgage is invariably the cheaper of the two, you could be forgiven for thinking that buying your own home in Japan is a sound decision just because the cost of the money is lower. As is often the case though, cheaper does not necessarily mean better.

Many people perceive debt as a very bad thing- this is particularly true in Japan. Any money borrowed is indeed a financial obligation. That debt has a servicing cost- the annual interest on the loan, and the consequences of failing to pay are sometimes severe. Mortgages are the largest debt obligation that you will likely ever take on in your entire life. Despite this, people will feel more comfortable taking out a residential mortgage for their own home than an investment mortgage. They perceive the investment loan to be higher risk. This is a mistake. Even if the interest rate on an investment loan is twice the size of that on a residential loan, the overriding difference between the two is that it is you that will be paying the bank back for your home loan, and it is somebody else that will be paying back the bank for your investment loan- your tenant(s). You will be meeting 100% of the cost of your home loan, and potentially 0% of the cost of your investment loan (working on the premise that you have bought a real estate asset that is cash-flow positive).

Conceptually, this is the idea of debt as leverage. Your 10% – 30% paid to the bank on day one allows you to control and take ownership of 100% of an asset. You rent out the asset to tenants. They pay you money. You pay some of that money back to the bank. At the end of the repayments, you have paid back the bank and you now own the asset 100% outright with no debt. You A) sell the asset to receive 100% of the property value, or B) continue to rent it out, receiving 100% of the rent proceeds each month.

The Golden Elephant In The Room – Passive Equity

The agreed appeal of real estate investing is that people pay you money each and every month, and you do not have to do anything in return. If you have bought that real estate outright using your own money, then calculating your gross return is relatively simple- like that of a government bond or other fixed interest investment:

(Annual income from the asset / Price paid for the asset) X 100

Investor 1

– Lets imagine an investor buys an apartment building for 80,000,000 JPY
– The investor buys with his cash savings
– There are x9 units in the building
– The tenants each pay 60,000 JPY per month
– Annual income would be 60,000 JPY X 9 units X 12 months = 6,480,000 JPY each year
– Gross yield for the investment would be calculated as ( 6,480,000 / 80,000,000 ) X 100
– Gross yield is 8.1% p.a – not bad at all.

Lets take a look at the same scenario again, with an investor using loan financing…

Investor 2

– The investor buys an apartment building for 80,000,000 JPY
– The investor gets a loan from ‘Megabank Japan’
– The terms of the loan are 20% downpayment, 30 year repayment term, 2% annual interest (APR), fixed rate
– Downpayment = 16,000,000 JPY
– Loan amount = 64,000,000 JPY
– Monthly repayments = 237,000 JPY per month (consisting of 178,000 JPY in principal paydown and 59,000 JPY in interest expense)
the same property as before…
– There are x9 units in the building
– The tenants each pay 60,000 JPY per month
– Annual income would be 60,000 JPY X 9 units X 12 months = 6,480,000 JPY each year
– Gross yield for the investment would be calculated as ( 6,480,000 / 80,000,000 ) X 100
[however] this is incorrect, because the investor has only used 16,000,000 JPY, and not 80,000,000 JPY as above. He also does not get to keep all the rent, because he has to pay back the bank each month…
– The return on capital (ROC) –note the calculation is different to the above– would be calculated as (gross rent received – bank repayments) / money spent X 100
– The return on capital would be (6,480,000 JPY annual rents – 2,844,000 JPY in bank repayments) / 16,000,000 JPY X 100
– The annual return on capital is 22.75% p.a – not bad just got a lot better…

 

The Masterstroke

Any calculation of net yield should really take into consideration all costs that detract from the money you are left with at the end of the year. The largest expense that any investor will likely have when investing is tax. When you receive rent, you are receiving income, and you pay income tax on that money as a result. Investor 1 does not have to pay any money to the bank, so he receives 100% of his rents. Investor 2 has to make repayments to the bank so he is left with less money in his pocket at the end of each month. So who pays more tax? Investor 1. Because he is not able to use mortgage related expenses to reduce his tax base.

This is where it gets interesting. Out of the 237,000 JPY that Investor 2 pays to the bank each month, 178,000 JPY goes towards paying off the loan. With each payment he increases his ownership or ‘equity’ in the property. Increases in equity are not taxed. Come the end of the 30 year repayment schedule, with his initial payment of 16,000,000 JPY Investor 2 becomes the outright owner of the 80,000,000 JPY asset. Who has had higher annual returns? Investor 1 or investor 2?

  • Investor 1’s annual returns are the annual income received divided by the cost of the property
  • Investor 2’s annual returns are the annual income received, minus loan expenses, plus the annual passive equity, divided by the capital paid in

Because of this the calculations required will be different in each condition:

Investor 1: simple gross yield
Investor 2: equity dividend rate/ cash-on-cash / return on capital

Annualised returns

Investor 1: +8.1% p.a
Investor 2: +22.76% p.a

Back To Reality

There are lots of caveats here. We have not talked about the effect of the tax on the rents received when calculating yield. We have not considered tax on sale of the property (if the investor ever does choose to sell). We have not considered using depreciation expense throughout the ownership period to lessen the tax liability on the income. We have not included any annual expenses for maintenance and management. We have not included any transaction costs. We have not accounted for vacancy. We have not accounted for rent compression. There are a lot of things that prevent the above simulation from being mathematically sound.

However. The premise still stands. Your return on an investment is what you get back, relative to what you put in and passive equity growth in a property is the closest that you will get to tax-free money.

Why Real Estate Is The Best Asset Class (Part 2)

8 Reasons Why Real Estate Is The Best Asset Class (Part 1)

Transaction Costs For Japanese Real Estate Buyers

Taxes For Japanese Real Estate Investment

What Is A Cap Rate?

Why Tenants In Japan Are Great Investments

Holding Companies: Investing In Japanese Real Estate

Investment Loans: How To Choose The Right One

5 Point Checklist Before Investing In Real Estate

How To Calculate Your Breakeven Occupancy Ratio

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