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July 19th, 2016 by Keith Weinhold
With real estate, people often don’t understand how an investor is paid. I mean, stocks historically provide an annual rate of return of about 10% and are low hassle. Comparatively, real estate values historically only return about 5% annual appreciation…and with more hassle! Right? So then how can real estate be a good investment? Once you know the answer to this question and act, wealth creation begins. I’ll start showing you how right now.
See… real estate investors commonly earn total rates of return of 30% to 40% annually. Or much, much more. Most importantly, this is often done passively as a property manager looks after the property and sends you the check – mailbox money!
Well, wait a second. How does a 5% return from appreciation commonly convert to rates of return of 30% to 40% or more? Understanding this is key. Because a great rate of return is what we want. We want to do more with less. The truth is, real estate investors benefit from five profit centers at the same time: 1) Appreciation. 2) Cash Flow. 3) Loan Amortization. 4) Tax Benefit. 5) Inflation-Hedging.
On a typical property, leveraged appreciation might account for a 25% return, cash flow another 8%, loan amortization 5%, and tax benefits another 2%, for a total annual rate of return of 40% on your down payment. Because this is a column, not a book, let’s just look at the first of these five profit centers – appreciation.
Not just appreciation. When you take out a loan, you can benefit from leveraged appreciation, which makes a 5% appreciation rate effectively much higher. “Appreciation” means the rise in value of the property. What does “leveraged” mean? Let’s look at this example.
Let’s say you put a $20,000 down payment into a small two bedroom, one bathroom, $100,000 single family home. The property appreciates 5% after the first year. Not very thrilling…right? Your $100,000 property is now worth $105,000.
Well…wait a second. Your $20,000 down payment just earned the $5,000. So you’ve still got the $20,000 invested, plus a $5,000 return on that initial investment. That’s a 25% return on your investment! Additionally, it’s a 25% return from only one of the five real estate investor profit centers. Add in the other profit centers, and you may have a total rate of return of 40%.
That’s right. The 25% leveraged appreciation rate of return doesn’t even include your rent income left over after all the monthly expenses from the property have been paid from the tenant’s rent, your loan paydown that the tenant is paying for, or your tax or inflation-hedging benefits.
Leveraged appreciation is independent of that. So…wow! Now how exactly did this happen? Though you only have true “ownership” of a portion of the property, you control the entire $100,000 property – both the $20,000 down payment portion plus the $80,000 portion that you borrowed from the bank.
Real estate investors learn that control is more important than ownership. (The tenant rent controls your monthly payments on the $80,000 loan to the bank…so that’s covered too). Is this magic? Is this something new? No, controlling a total asset with a small down payment is called financial leverage. Is this risky? No, it is relatively stable. Think about it – real estate is everywhere. Shelter is vital to human life. People have needed real estate from the time that Neanderthals lived in caves until tomorrow when an iPhone app developer applies for a Manhattan micro-apartment.
Despite a rapidly-changing world, no one is predicting that real estate will go away, even far into the future. A stock can lose ten percent of its value in one day. Real estate is more stable. Are we using some sophisticated and fleeting real estate technique that will soon dry up? Not at all. This is just plain old buy-and-hold real estate investing.
In fact, governments strive to make sure that home ownership is sustainable. They ensure that home loans are available to borrowers and investors in order to keep real estate viable. Governments commonly subsidize home loans. Then they provide ongoing tax benefits for homeowners.
What about the hassle that comes with real estate investing? Instead, you can buy and sell stocks by merely pointing-and-clicking in your eTrade or Scottrade account. Hassle is mostly overcome by building the cost of a property manager into your real estate purchase. Your time is too valuable to be fielding calls from tenants or dealing with repairs.
Leveraged appreciation is largely how real estate wealth is not earned, but made! Are you excited yet? Well, it gets better. Remember…this leveraged appreciation is one of only five ways that real estate pays you simultaneously!
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