COLUMN: Real Estate 2.0 – The Magic of Compound Interest

Q:  My wife and are in the process of buying a duplex as an investment and we are having a disagreement over how to structure the financing.  My idea is for us to pay all cash and then be able to pocket all the rental income. She says we should put a minimum down and then finance the rest.  Who’s right? 

 Larry

A:  Well, Larry, your wife is right. Of course she is right.

Albert Einstein, when asked what the most powerful force on Earth was, answered, “compound interest.”  He also called it the “8th wonder of the world.” Ben Franklin called compound interest the “stone that will turn lead into gold.”

Oooh la la, compound interest + leverage = phenomenal profits!

Surely you are aware of the concept of compound interest. This is the concept that banks tell you about when they explain how your money will grow exponentially over time. You make a deposit at the bank. You then leave your original investment plus your interest alone. In time the interest earned on the interest of your original investment makes your return grow like wildfire.  Easy as pie.

Einstein called compound interest the ‘8th wonder of the world’. Ben Franklin called it the ‘stone that will turn lead into gold.’

Well, the same concept holds true for any leveraged real estate investment.

The truth is if you paid all cash (without the benefit of getting a loan) the return you will get on real estate would not be much higher than you would get on most any other type of investment. With real estate, however, it is not only common, but really, usually necessary to use leverage to buy properties. That is, you put a reasonable amount of money down and then you finance the balance, just as your wife is suggesting you do.

The key is this: The ability to use leverage with real estate significantly increases the percentage of profit you can make, and just as importantly, it allows you to purchase a significantly larger investments than you normally would have been able to.  

Let us say that you have $10,000 to invest.  With that $10,000, you could buy $10,000 worth of stocks, bonds, coins, or art.  With $10,000 to invest in real estate, however, you could buy a four-unit FHA apartment building worth almost $300,000.  How could this be so?  It is so because 3.5 percent is all the FHA requires you to put down on a residential one to four unit property.

But first we should do it your way.  Let us say that you buy that duplex with $100,000 of cash outright. If so, your cash flow might look this:

Property price           $100,000 investment

Gross income             $14,000

– Expenses               -$4,000
__________________________________
Net cash flow            $10,000

Your profit as a percentage of your investment would be calculated using the following formula:

Net income
______________ = % return
Investment

Therefore, your profit would be

$ 10,000
_____________ = 10% return
$ 100,000

Ten percent on your money is pretty good, right?  Sure it is, especially if you are used to the return you get from your savings account.  But now let’s use the power of leverage and try this again.

This time we will put just 10 percent down and borrow the remaining 90 percent of the purchase price.  As an example, let us say that the loan on the property is 5%. Using these facts the loan costs $483.00 per month.  Your cash flow on the building is now:

Gross income             $14,000

Expenses                 -$4,000

Loan payment           – $5,796
______________________________________
Net cash flow             $4,204

Okay, you will see that compared to buying the property outright that your cash flow drops from $10,000 per year to $4,204. At first glance this does not seem so good – sure, that is true, that is until you examine what that means in terms of a percentage return on your investment.

Because your down payment was not the whopping $100,000 you would have had to put down by paying all cash, but instead is only  $10,000, the return now looks like this

Net income
_______________ = % return
Investment

Or:

$4,204
____________ = 42% return
$10,000

Yes, that number is correct, sir – 42%.

Think about it; if you were to do it this way you could buy ten of these properties with the same $100,000.  If so your annual cash flow would be $42,040, and that’s a number you cannot scoff at.

When you combine the power of leverage with compound interest, we know from both experience and basic math that you can make phenomenal returns.

So you see, your wife was right. She always is.

Have a question about real estate investing for Spence and Marty? Email them at [email protected].

NO COMMENTS

LEAVE A REPLY