“A discovery is said to be an accident meeting a prepared mind.” – Albert von Szent-Gyorgyi
When you’re a real-estate investor, you’re essentially in the business of finding investors to back your projects. Those investors are lending institutions or private lenders. They receive interest payments from you and, initially, loan fees. You get to keep the profits. This is what is called “positive leverage.” It means you can ratchet up your profits by using other people’s money to control an appreciating asset — and it’s the first great advantage that real estate has over the stock market.
If you know what you’re doing and how to target value and a wide “margin of safety” in the form of fat net rents, here’s what you can expect from leverage:
If you buy a $100,000 house with 20% down and it goes up 6% in a year, you’ll have made 30% on your investment. Add in $1,000 in net rents (after all carrying costs), and you’ll have made 35%. What’s more, you can do even better in a strongly appreciating market.
Not long ago, I purchased a $200,000 property with 10% down. I chose it because it was selling at a discount to other properties in the neighborhood and I was convinced the neighborhood was the next to “take off.” Turns out I was right.
In just over two years, the property value rose to $350,000 — returning $150,000 on my original $20,000 investment. Even counting closing costs, that’s more than a $140,000 gain. Seven times my money in three years — and this was during the bear market in stocks.
And leverage isn’t the only benefit that real estate has and stocks don’t have. In addition to leveraged appreciation on an investment property, you also collect net rents. By “net rents,” I mean what’s left over after you’ve paid all the property’s carrying costs, including mortgage payments, property taxes, insurance, maintenance, property management, and an allowance for vacancy (usually 10% of the potential gross income).
MMF and I recently made a $50,000 investment (including the down payment and closing costs) to buy a four-unit building that throws off $500 a month after all expenses. That’s equivalent to a 12% yield. (Try finding that in the stock market.) What’s more, it’s on top of an appreciation of $20,000 in the first year.
But the real beauty of net rents is that, just like a dividend from a good company, they tend to grow over time. That’s because your mortgage (the biggest part of your carrying costs) should stay fixed or even decline (if interest rates fall and you refinance).
In other words, a property that’s generating $500 net a month today could easily generate $1,000 a month 10 years from now. And if you’ve accumulated 10 such properties during that time, you may be in a very nice position to live off your passive income — even after paying someone else to manage your buildings. For long-term purchases, amortization (the process of reducing your loan balance) is another way you profit from real estate.
Say you buy a $100,000 property with $20,000 down and pay 3% ($3,000 in closing costs). You hold it for 12 years, and it goes up 6% a year (which is the long-term average). The property is now worth $200,000. The property has doubled in value, but you’ve done far better. Your original $23,000 has picked up $100,000 in capital gains. But that’s only the beginning of the story. You also have picked up net rents. Over 12 years, if you’ve bought right, it’s very reasonable to assume you’ve netted an average of $100 a month in net rents during that time … or added an extra $14,400 to your bottom line. But we’re still not done.
At the same time, you’ve been using part of your rental revenue to pay off the mortgage. On a normal 30-year amortization schedule, you’ve paid off about 17% of the mortgage after 12 years. That means you’ll no longer owe $80,000 when you sell … you’ll just owe about $67,000. That adds another $13,000 to your bottom line.
Add it all up, and your original investment of $23,000 has produced gains and income in excess of $127,000 in 12 years — while the market has increased only by its long-term average rate of 6% a year!
As an investor, you also get the benefit of depreciation. This is a charge you take against your income to reduce your taxable income, yet it is a non-cash outlay. In some circumstances, depreciation of investment properties can be used to offset income not only from the property itself but from other sources as well.
And then there are the intangible benefits — such as the satisfaction of taking a rundown property and bringing it back to life, bringing up the value of the entire neighborhood in the process.
(Ed. Note: Justin Ford is the editor of Main Street Millionaire.)