Real Estate without the Hype
Real estate offers an opportunity for building substantial wealth for the average investor that is not available in any other type of investment. It does not take special inside information or special insight, but a disciplined, steady investment plan. The focus should be on building assets – building wealth.
What about income you ask? If one investor has $1,000,000 in assets and another has $100,000, which will be able to generate the most income (current cash flow)? It’s clear that the greater the assets, the greater the potential for income. Therefore, the focus of this paper, and the focus of a good investment plan should be on building assets, so that the future potential for income is enhanced. The assumption is that income is a future, rather than present, goal. (You may wish to refer to Generating Cash Flow.)
Building wealth is a matter of applying three fundamental principles:
1. Use the power of compounding and let time work for you.
2. Lever your capital to enhance your return.
3. Protect your gains from erosion from taxes.
4. Let’s look at these one at a time
The power of compounding
A $10,000 investment, if left to grow at 8% without withdrawal, will grow to $21,589 after 10 years, $67,275 after 20 years and $100,627 after 30 years. The following chart further illustrates this principle for other periods and returns.
The lessons are several.
1. The longer time you have to invest, the more dramatic the effect.
2. A small change in the rate of return will yield a major impact over time.
3. It is not necessary to achieve extra high returns to build substantial wealth.
4. Patience helps, as this is not a great rich quick scheme. The growth in assets gains pace over time.
Use leverage to enhance your yield
The following simple example illustrates the principle of leverage, or using other people’s money for your benefit. Admittedly the example is overly simplistic, but there is no question that the prudent use of leverage will enhance your returns. If you re-examine the compounding table above in light of the enhanced yield available from leverage, you can see the dramatic impact of the two principles working together.
Protect from erosion from taxes.
The chart of compound returns above that illustrates the future value of an investment left to compound assumes no erosion from income taxes. If you were to pay income each year on the gain or other taxable amount, the future value would shrink dramatically.
Again, real estate investment offers some advantages not available in other investment vehicles.
The leverage that enhances yield is also helpful in avoiding taxes because the interest is tax deductible. Remember, gains from appreciation are not taxed until they are realized by sale.
By setting the level of debt so that current taxable income is minimized, the erosion is largely eliminated. Most of the gain comes from appreciation, and that is not taxed until it is realized from a sale. A strategy to maintain a certain level of debt, and to hold assets for the long term can generate substantial gain from appreciation with very little erosion from taxation, and thereby allows a savvy investor to achieve the kinds of results contemplated by the compounding table above.
Application for the three basic fundamentals of real estate investing described above virtually assures an investor will build a substantial investment portfolio. It is not necessary to have special insight, inside information or to be especially lucky. Anyone with discipline can execute this formula for success.