Residential real estate has been the source of millions of dollars in wealth for some of the world's wealthiest people. You may have wondered just how to create wealth by investing in real estate.
The biggest factor that real estate investors can use to accelerate the growth of their wealth is leverage. Leverage is the use of borrowed money -- usually mortgage debt when referring to real estate -- to increase the potential return of an investment.
And leverage, when used wisely to purchase income-producing real estate, is a very powerful tool. It can translate into some pretty impressive returns and literally multiply your wealth over time. It's not uncommon for an investment property purchased with 20%-25% down to deliver annualized returns of 15% or more. Let’s take a look at an example of how this works to give you an idea of the power of building wealth through real estate.
Building wealth by the numbers
Let's say you buy a residential rental property worth $100,000 with a down payment of $20,000 (20%) and take out a mortgage of $80,000. With fees and closing costs, your cash outlay the first year might be $25,700.
You are now controlling -- and benefiting from the income produced by -- an asset worth $100,000 by investing just $25,700. Let's say that you can rent this property out for $1.350 a month. Assuming expenses of $11,000 a year, the property produces a cash flow of $5,200 annually. That's an annual return of over 20% on your initial investment of $25,700. While not guaranteed, rates of return at this level aren’t uncommon.
|Rental property purchase price||$ 100,000|
|Mortgage (80%)||$ 80,000|
|Downpayment (20%)||$ 20,000|
|Closing costs||$ 5,700|
|Total cash outlay -- Year 1||$ 25,700|
However, that's just part one of the wealth-multiplying effect. In addition to benefiting from annual cash flow, your tenant is essentially paying down your mortgage.
|Metric||Year 1||Year 2||Year 3|
|Cash outlay||$ 25,700||$ -||$ -|
|Total annual rental income||$ 16,200||$ 16,200||$ 16,200|
|Total annual expenses||$ 11,000||$ 11,000||$ 11,000|
|Positive cash flow (net annual profit)||$ 5,200||$ 5,200||$ 5,200|
|Annual ROI on initial investment||20.23%||20.23%||20.23%|
Let someone else cover the mortgage for you
This mortgage paydown steadily builds your equity ownership in the rental property. The longer you own the property the more equity ownership you accrue and at a faster pace year after year. In year three of this example, your loan balance is reduced to $77,473.
The property you purchased for $100,000 is now worth $106,090. Essentially, you owe $77,473 on a property worth $106,900, providing ownership equity o $29,927. And your equity ownership also gets a boost as your rental property appreciates in market value. According to the Case-Schiller National Home Price Index, homes have increased in value at a rate of 4.9% annually over the past 25 years.
|Metric||Year 1||Year 2||Year 3|
|Mortgage balance||$ 80,000||$ 78,718||$ 77,473|
|Annual equity growth||$ 1,282||$ 1,245||$ 1,310|
|Property value (appreciating at 3%/yr)||$ 100,000||$ 103,000||$ 106,090|
|Total equity ownership||$ 21,282||$ 25,527||$ 29,927|
Now think about doing this same scenario with 1 or 2 properties each year or by acquiring a multifamily building like an apartment complex. You get it, you accelerate the process and build wealth exponentially (at least theoretically, it takes a substantial amount of market knowledge and real estate experience to do this successfully in real life).
Of course, the overuse of leverage is a risky gamble and can be devastating financially. Homeowners and some investors were faced with owning properties that had lost market value after the housing bubble burst a decade ago.
However, the smart use of leverage can be a great wealth-multiplier when investing in real estate that’s much safer than using leverage to purchase stocks.
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