August 15th 2018
Last issue we introduced the concept of leveraging, or making money through the use of borrowed money. In the case of rental real estate we saw that where a straight cash purchase might generate us a 6% return in our money invested, by putting only 20% of our own money into an investment and borrowing the rest, our rate of return grew to 15%. Then when we considered a situation where we invested just 10% of our own money and financed 90% of the purchase price, our rate of return soared to 26.25%.
But that’s only half the story. It gets even better. Remember, real estate creates wealth in two ways. First, as we’ve just considered, it generates an income stream from rent. But real estate also appreciates over time. And this capital appreciation can also be enhanced through the power of leveraging.
Lets suppose, on average, real estate goes up about 2.5% a year. That’s about the rate of inflation or cost of living. It’s fair to say that that’s a conservative estimate because if real estate didn’t go up at least at the rate of inflation, it would be getting cheaper and cheaper to own property. As we all know from experience that isn’t happening. In fact, I contend that real estate over time will go up at a greater rate than inflation and I think historical evidence bears that out. That’s because of the principal of scarcity. They aren’t making any more land. So whether you’re talking about waterfront, or land close to downtown, or in a particular subdivision, there’s only so much available. As populations grow and demand increases, it creates added upward pressure in prices.
But lets be conservative and assume an annual appreciation rate of 2.5%. (Of course the appreciation isn’t uniform. One year prices may not go up at all. Some years they may drop slightly, while other years we may see 10% or 15% increase. Overall, however, if we assume an annual price increase of 2.5% we’re safe and even conservative). If we go back to the situation we raised last newsletter and assume a property with a value of $200,000, that means that at the end of one year the value will increase by $5,000 to $205,000. If we paid cash for the property, we would see a return on our investment of 2.5% due to capital appreciation.
Okay, now lets apply a little leverage and assume we invested only 20% of our own money to make the purchase and borrowed the rest. So how did we do on our investment?
By reducing the amount of our money invested in the property to 20%, we’ve increased the impact of the appreciation in value when seen as a rate of return on our investment. In this case from 2.5% to 12.5%. Why is this so? Because the entire property appreciates in value, not just the amount of money we invested in it. And if we reduce the amount of money invested from 20% to 10%, our effective rate of return increases that much more. Look at the numbers when we put only 10% of our own money down on the purchase.
When you consider the combined impact leveraging has on both income stream and capital appreciation, you start to get an idea of how powerful this economic principal is, especially when applied to real estate investment. Look again at the numbers when we consider the purchase of a $200,000 rental property with a rental rate of return of 6% and an annual capital appreciation rate of 2.5%.
When I pay cash, I see a return of 6% from cash flow and another 2.5% from capital appreciation. That’s 8.5% combined. Not bad. When I use only 20% of my own money, the effective rate of return from rental revenue grows to 15% as we’ve seen. Along with a 12.5% return from capital appreciation. That combines to about 27.5%.
And when I reduce my cash investment to 10% of the purchase price, my rate of return from rental income jumps to 26.25% and I realize another 25% from capital appreciation. That combines to over 51.25%. Wow!
Of course, the actual amount of money generated has changed little from one scenario to the next. What has changed is the amount I’ve invested and so the effective rate of return grows. But what if, instead of reducing the amount of money I invested, I used the principal of leverage to purchase more real estate? With $200,000 to invest and no money borrowed, I could buy $200,000 worth of real estate. But when I put only 20% down and borrow the rest, with my $200,000 I can buy 5 - $200,000 properties or a total of $1,000,000 worth of real estate. And if I choose to put only 10% down, my same $200,000 investment can now purchase $2,000,000 worth of real estate. Now work the numbers. Capital appreciation alone, based on 2½%, becomes $50,000 annually. And if I use the excess rental revenue to pay off the debt, once the mortgage is paid off, the investment at 6% will generate me $120,000 annually. Not bad for a $200,000 investment.
A few articles back I promised I’d show you how you could conservatively expect to receive 20% return on your real estate investment. We’ve achieved a lot more than that. But now, in our next issue, I’d like to go back to that promise. I’d like to use a typical blended mortgage and set out for you a conservative investment strategy, which will ensure that 20% return.
Wayne Quirk, Author
“THE MONEY MACHINE”
wayneq@remax-gc.com