September 15th 2018
Whenever we buy a piece of real estate, one option we have is to pay all cash for it. This isn’t often done, however, for a couple of reasons. For one thing real estate is a lot more expensive than most other things we purchase. In fact, if paying cash were the only way to buy real estate, home ownership would be out of the reach of most of us. It’s hard enough to save for a down payment. Most people would never be able to put aside enough money to pay for a property in one huge sum. But another reason, as we’ve seen in the last couple of newsletter articles, is that from an investment standpoint putting a relatively small amount of our own money down on a property actually makes a lot of sense. It’s a principal known as leveraging, and through it, our return on investment can be greatly increased.
Before I proceed too much further with this thought, however, I want to be sure we’re all clear on what is involved in financing a real estate purchase, and how that debt is eventually paid.
Whenever we refer to a real estate loan, we use the term mortgage. Actually a mortgage is the security given in exchange for a loan. The bank gives you money and in return you register a security (mortgage) against the property.
Every mortgage has a certain set of conditions. What is the rate of interest being charged? How is it to be repaid? Are the taxes included in the payments? And so on. For our purposes, there are two aspects of the mortgage that it is important for us to understand. ‘Term’ and ‘Amortization’. The ‘term’ is the period of time the bank or lender is prepared to make a commitment for. Generally the term runs anywhere from six months to five years, although terms can run up to ten years with some lenders. During the term of the loan, the interest rate and amount of the payment is generally fixed.
Mortgage loans are usually repaid in what we call blended payments. By this I mean that each payment made to the lender is composed of part principal repayment and part interest. The total size of each payment remains the same, but each month as the principal amount of the loan is reduced, the interest portion of the payment decreases. Consequently with every payment the amount of the loan you repay increases. The amortization period is the amount of time it would take, all things being equal, to pay off the loan. The longer the amortization period, the smaller the total size of each monthly payment (slightly) but the greater the amount of interest you will ultimately pay. I council people to, if at all possible, never amortize a mortgage at more than 15 years.
With that in mind, let me show you how simple it is to invest in real estate and enjoy a 20% return year after year. Let’s suppose you buy a piece of real estate and put 25% down. Now as we’ve seen in our last couple of newsletters your return is even greater when you put less than 25% down. And in fact, when you can, you should buy with 10% down. For one thing it’s a lot easier to save up to 10% than it is 25%. But let’s be conservative. If we’re looking at a $100,000 purchase, that would involve putting $25,000 down and arranging a $75,000 mortgage.
Now, here’s the critical part. Amortize the mortgage over 15 years. Never more. With 25% down, and with a 15 year amortization, the rent should easily carry the mortgage and other expenses. If there is a surplus, use it to shorten the amortization even further, or give yourself a slush fund for unexpected expenses. Don’t spend the money. With every payment you are reducing the debt. And a 15 year amortization gives you exactly 10% return on your money. How do we know? Well, when money is invested at a compound interest rate of 10% it doubles about every 7 ½ years. Or in 15 years it doubles twice. But look what happened to your investment equity in 15 years. Forgetting for the moment, the fact that the property has appreciated in 15 years, you’ve also paid off $75,000 in debt. Your equity has grown from $25,000 to $100,000. It’s doubled twice. You’ve got a compound rate of return of 10%.
But at the same time, the property has gone up in value. Let’s assume a conservative 2.5% annually. That means in the first year, the property increased by $2,500. But remember, you only invested $25,000 of your own money. $2,500 growth on $25,000 invested. That’s another 10% return. So with 25% down and a 15 year amortization we’re getting 10% return from the rent paying down the mortgage. We’re also getting 10% from capital appreciation. 10% + 10% is 20%. And that’s conservative.
Incidentally, have a look at what’s happened over time. Even at only 2.5% of annual growth, in fifteen years the property will have increased in value to $145,000. That means your annual growth rate now is $3,625 and increasing. And of course your rent is increasing annually as well. The only thing that isn’t increasing is the amount you originally invested. Today you should get about 6% net return from your investment. Based on the original purchase price of $100,000 that’s about $6,000. Even if it hadn’t gone up in 15 years, you’re still making $6,000 from rent and $3,625 from appreciation. That’s $9,625 annually. On a $25,000 investment, that’s 24% return from the rents and another 14.5% capital appreciation. That’s about 40% annual return. I think you’ll agree that you can’t get that from a G.I.C.
Wayne Quirk, Author
“THE MONEY MACHINE”
wayneq@remax-gc.com