The nuts and bolts of a property investment decision include the strategy that one uses, the township that one selects and individual property asset. There are two other resources which are akin to the grease and the oil.
The first is the power of leverage.
Leverage is a physics term used to describe moving a big object with a small amount of force.
In the property world, leverage is the process of using borrowed capital to acquire an asset of greater value.
The second is compounding.
In a financial parlance, compounding is the process of continued asset growth over time while reinvesting the earnings from that asset.
I’ll throw in another grossly underestimated resource – time. Like leverage and compounding, time is a resource available to everyone, but time is limited in supply.
Everyone has 24-hours in a day and 7-days in a week. Most people also have approximately 45 years in the workforce. But it is what one days with all that time that determines what life looks like beyond then.
Each of these resources are particularly powerful tool for those who invest in real estate.
EXAMPLE
Mark and Mary both have $60,000 cash that they have saved up. They also have the intention of religiously setting aside $1,000 additional cash every month for the next 10-years.
Mark chooses to invest his money in a defensive asset – a term deposit.
Mary takes out a loan of $540,000. She adds her $60,000 cash (10 percent deposit) and purchases a $600,000 investment property. This is leverage.
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To avoid any bias between asset classes, we will assume that both Mark and Mary achieve an average annual investment growth rate of 7.2 percent.
We’ve used 7.2% for the simplicity of the mathematical ‘Rule of 72’ (for an asset to double in value over 10-years it will need to grow by an average of 7.2% each year).
Mark’s investment does not have any expenses.
We’ll assume that the 7.2 percent interest on Mark’s term deposit is paid monthly and compounded – added to the original $60,000 investment. And Mark continues to add an extra $1,000 per month.
Mary has expenses that include interest on her loan, insurance for her property asset, city council rates and the ongoing costs to maintain and manage her investment.
Mary’s asset also receives income – weekly rent for the provision of housing.
Realistically, in this current interest rate climate, annual expenses for Mary’s $600,000 property would be approximately $12,000 per year more than the annual income. This is referred to as negative gearing (‘gearing’ means debt / leverage while ‘negative’ relates to the cash flow).
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Mary’s commitment to set aside $1,000 every month covers this cash flow shortfall.
After 10-years, both Mark and Mary will have contributed $180,000 of their own money (the initial $60,000, plus an extra $1,000 per month).
Mark’s $180,000 total investment will have increased in value to $298,000.
As they say, from small things, big things grow.
In this case, the discipline of depositing $1,000 per month into the bank and leaving it there, combined with compounding interest, has seen it grow to $298,000.
Using the same amount of money and the same time frame as Mark, Mary’s asset has increased from $600,000 to $1,200,000. After subtracting the $540,000 loan, the net value of her investment is $660,000.
The power of leverage in this example means that Mary’s net asset value after 10-years ($660,000) is 121% more than Mark’s ($298,000).
** To avoid unnecessarily complicating things, the above example excludes property acquisitions costs in each state such as stamp duty and no provision has been made for legitimate tax deductions such as depreciation and negative gearing benefits.
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