The Chance of a Lifetime
It is possible to achieve financial
independence in ten years or less. In fact, the wealth of our nation is such that the failure to do so is to have missed the
chance of a lifetime.
There are several factors unique
to our present financial realities that make it easier than ever to achieve financial independence in only a few years.
Among those, two are the primary
basis of the plan briefly outlined below:
1)
The relationship between average income and the cost of real estate in the United States;
2)
The effect of inflation on the rental market for residential real estate.
In a nutshell, rents go up
while the costs of owning residential properties, held over time, actually go down. In that delta between costs and income
is the means to achieve financial independence, whatever color your handcuffs today might be.
In a slightly enhanced nutshell,
the plan is this: You will buy a house and keep it for two years while you save to buy another.
At the end of two years, you
will buy another house, rent out the first house, and move into the second house while you save money to finance your third
house in two more years.
These steps you repeat until
you have a total of four houses you are renting and your personal residence for a total of five houses. To get to the point
of owning five homes will take eight years.
At ten years, through rent
increases and a strategy of refinancing, the plan is to replace your earned income with investment income.
Now, let’s take a look
at how inflation will drive up the value of your properties and, with it, your net worth and rents.
For the sake of example, we
need to make a few assumptions. Throughout this exercise we will assume an annual appreciation rate of five percent. That
is, we are assuming that the value of the property in our example is going up five percent each year.
So, a property purchased for
$100,000, one year later will have a value of $105,000.
The important fact to consider
is that this equation does not progress in a straight line and the value at the end of year two does not increase by another
$5,000 but rather $5,250.
Albert Einstein called compound
interest the eighth wonder of the world. What do you think he would have thought of compounded appreciation?
Compounded appreciation, that
is, appreciation of appreciation, is what makes real estate the powerful wealth
generator that it is.
This is a ten-year chart of
compounded appreciation for our example property with a value of $100,000 in the year purchased. (In the table, the letters
EOY are an acronym for end of year.)
EOY Year
Value
1
105,000
2
110,250
3
115,762
4
121,550
5
127,628
6
134,010
7
140,710
8
147,745
9
155,132
10
162,890
Meanwhile, assuming the purchase
was originally financed using a 20 year mortgage with an interest rate of 8% the balance on the loan at the end of year ten
would be $68,940.
Doing the math, that means
that we would have equity in this one property of somewhere in the neighborhood of $95,000.
Now, that’s not bad neighborhood
considering all you did was live in this house for ten years and make the mortgage payment every month. That’s why I
call real estate the best investment in town!
But what if you had bought
another property every two years over that same ten year period? What would your net worth be at the end of that same ten
year period?
EOY Year House 1 House 2 House 3
House 4 House 5
1 105,000
2 110,250 100,000
3 115,762 105,000
4 121,550 110,250
100,000
5 127,628 115,762
105,000
6 134,010 121,550
110,250 100,000
7 140,710 127,628
115,762 105,000
8 147,745 134,010
121,550 110,250 100,000
9 155,132 140,710
127,628 115,762 105,000
10 162,890 155,132
134,010 121,550 110,250
RB% 68.94
77.27 84.38 90.43 95.60
RB$ 68,940
77,270 84,380 90,430
95,600
Equity 93,950
77,862 49,630 31,120
14,650
Total Equity: $267,212
The figures above assume a
$100,000 purchase price with no money down, what if you put $10,000 down on each purchase? In that case, your equity would
be well over $300,000.
During your acquisition phase,
that is, during the eight years when you will be purchasing your five houses, you might want to consider conserving cash to
fund each subsequent purchase.
Large chunks of money are hard
to come by. Even if you have an extra $10,000 cash available to fund a larger down payment, you might want to consider holding
on to it to fund the down payment on the next house.
Also, when you own real estate,
I am an advocate of having a worst-case scenario fund. Think of it as a war chest to fund unexpected repairs or extended periods
when, for whatever reason, you’re not receiving expected rental income.
The good news is that your
profit from appreciation will be the same regardless of the amount of money you put into each deal.
Not only that, the same amount
of appreciation will represent a higher return on your investment the less cash you put into each deal.
To illustrate my point, let’s
just say that you had put down $10,000 on your first house.
Notice that the appreciated
value is the same in both cases.
Zero Down
$10,000 Down
Appreciated Value EOY 10 162,890
162,890
Mortgage Balance EOY10 68,940
62,046
Equity EOY 10
93,950
100,844
Also notice what looks like
an argument against ever putting more money into a deal than is absolutely necessary to secure financing:
Your equity will be more at the end of year ten when you put $10,000 down but it will
not be $10,000 more.
But have you actually lost
money by putting more money down, as the figures seem to indicate? No.
Yes, that same $10,000 invested
in a certificate of deposit earning 6% a year after taxes, instead of in a property as down payment above what was required
to get financing, would have grown to almost $18,000.
So, why would anyone, then,
ever put more money into a real estate purchase than absolutely necessary to secure financing?
Because you can realize
a much higher return on your investment investing in real estate equity than you can do in almost any other similarly secure
investment.
In the example we’ve
been working with, the payment on 20 year, $100,000 mortgage at 8% is $836.45 while on the same mortgage for $90,000 the payment
is $752.80; a difference of $83.65 a month in favor of the lower mortgage.
Guess what? That $83.65 a month
represents a return on the investment of that $10,000 of almost 10%. That return is much better than you would get in a 6%
CD, obviously.
The lower the interest rate
on the mortgage, the lower the return on equity but even during times of historically rock-bottom mortgage interest rates,
the actual rate you will pay, or APR as it’s known, won’t ever be significantly lower than 8%, for the purposes
of this plan.
So, now let’s look at
what effect a $10,000 down payment actually will have on your bottom line, your Net Worth figure:
EOY Year House 1 House 2 House 3
House 4 House 5
1 105,000
2 110,250 100,000
3 115,762 105,000
4 121,550 110,250
100,000
5 127,628 115,762
105,000
6 134,010 121,550
110,250 100,000
7 140,710 127,628
115,762 105,000
8 147,745 134,010
121,550 110,250 100,000
9 155,132 140,710
127,628 115,762 105,000
10 162,890 155,132
134,010 121,550 110,250
RB% 68.94
77.27 84.38 90.43 95.60
RB$ 62,046
69,543 75,942 81,387
86,040
Equity 100,844
85,589 58,068 40,163
24,210
Total Equity: $308,874
Now, assuming that in addition
to the down payment you also paid $2,000 in closing costs, your total investment would be $60,000 over ten years, an average
of $6,000 a year.
What return on your investment
does that represent? Almost 28%! That is a truly amazing figure. The fact that returns such as those are fairly common in
real estate investing is what makes it the fabulous opportunity that it is.
How much would you need to
save to achieve the same net worth at an after-tax interest rate of 5% interest?
