Like a home, Real Estate rests on a “Foundation”
Every business needs to be built on a foundation. A solid foundation has four “cornerstones” on which the whole building (business) rests. To understand the true benefits of real estate investing one must fully grasp the concepts of these cornerstones. Once you study these foundational principles then the proverbial “light will come on”. The four cornerstones of investing are Leverage, Cash Flow, Principle Reduction and Appreciation. By utilizing all four cornerstones you will not have a foundation built on shifting sand, but one on solid rock.
“The use of fixed costs in order to increase the rate of return from an investment.” This definition from Webster’s says it all. Leverage will increase your rate of return. To understand leverage it is best explained by an example. What if you went to the bank and said that you have $10k but you want to buy $100k in an index fund. And you want the index fund to act as the security for the loan. What would they say? They would say forget it. Yet when you buy a house you can put down $10k for a $100k house and have the actual house ( similar to the index fund) act as your security. But here is where the real leverage works. Homes appreciate. What is appreciating is the $100k. Not just your $10k. If it appreciates at 5% a year then on $100k that equals $5k per year, or 50% on your original $10k investment. That means your original 10k grew at 50%, AND the loan is secured by the actual property. Try buying 100k for any stock offering with only a 10k deposit and then make 50% return on it.
“The amount of net cash generated by an investment or a business during a specific period” When we purchase a property we ensure that it has positive cash flow. Positive cash flow is the amount of money that is left over AFTER all expenses, loan payments, and taxes. We only buy a property that will cash flow at a minimum of 10% a year on real money invested. Using our example again if we invested 10k we would get a minimum of $83.00 per month in positive cash flow ( $83 x 12 months=$1000 or 10% of $10k)
When we rent out our properties our tenants pay our loan (mortgage payments). That means that at the end of the first year the original $100k mortgage loan is now worth only $98,222.00. That means you made $1778.00.
“An increase in price or value;” Simply put, real estate historically has gone up in value, i.e. it appreciates in value. As stated earlier if a $100k home appreciates at 5% a year that means in the first year it will be worth $105k.
Now lets put it all together by using our example of a 10k investment and see how much our total profit is. First off we use the banks’ money to buy the $100k house (leverage). Secondly, we then rent it out earning $83.00 per month in positive cash flow. Thirdly at the end of the year, our bank loan of $100k is now worth $98,222.00, which means we made another $1778.00 and finally at the end of the first year our property appreciated by 5% or in our case $5000.00. Let us add it all up. ($83 x 12) $1000 + $1778 + $5000= $7778.00. The bottom line is that your $10,000.00 investment has earned you a total of $7778.00 in one year! That equals a 77.78% return on your investment ( ROI) If you were to put that $10,000.00 in a GIC paying 5% you would have made only $500.00 in the first year. Has the “light” come on yet?