Creating Wealth with Apartment Buildings
FORMULA: INFLATION + LEVERAGE + COMPOUND INTEREST= PROFIT
INFLATION historically runs about 4% per year. Annual rental increases monetize inflation in real time. Definition of inflation: too much money chasing too few goods.
Warren Buffett quote: “Our outlook for inflation is always the same. We feel there’s a big bias toward inflation-both in theU.S.and around the world…It’s a world where prices are going up and up. It’s just a question of how much. You could definitely have some explosive inflation at some point. Printing money is just too easy. I’d do it myself if I could get away with it.” Annual meeting in 1988.
LEVERAGE is the use of borrowed money to increase profits on a real estate investment. Example: You purchase a house for $100,000 cash. The home increases in value to $110,000. You have made 10% on your money. You purchase the same home for $100,000 using a 10% down payment, and the home increases in value to $110,000. You have made 100% on your
$10,000 turns into $60,000 in 10 years. Here’s how it works: First year interest is added to principal, and then in year 2, the interest is calculated on the new amount. Example: $10,000 + 20% interest = $12,000. This makes your new principal $12,00.00. Year 2 =$12,00.00 + 20% = $14,400.00. Interest is earned on interest. This is the principal of compounding.
PUTTING IT TOGETHER
Purchase an apartment building with an annual rental income of $180,000. Price: $1,800,000, or 10 times the annual gross rental income. Make a 25% ($450,000) down payment. Increase the rents 5%. Multiply the % rent increase by the10 annual gross rent multiplier = $90,000 increase in equity. This represents a 20% return on your down payment, without considering cash dividends, loan principal reduction and tax advantages. Compound this 5% rent increase for 5 to 6 years and your $1,800,000 building is now worth roughly $2,300,000. We have doubledyour down payment in 5 years by increasing rents only 5% per year.
Annual income GRM Building value Down pmt. Equity % return
Yr 1: $180,000 10 $1,800,000 $450,000
Yr 2: $189,000 10 $1,890,000 $450,000 +$ 90,000 = +20%
Yr 3: $198,450 10 $1,984,500 $450,000 +$ 94,500 = +21%
Yr 4: $208,372 10 $2,083.000 $450,000 +$ 98,500 = +22%
Yr 5: $218,791 10 $2,187,000 $450,000 +$104,000 = +23%
Yr 6: $229,730 10 $2,297,300 $450,000 +$110,300 = +25%
The big advantage of owning real estate is to take advantage of the principal of compounding money. This is best explained by "The rule of 72": If you divide your desired compound rate of return into 72, you get the number of years required for your investment to double.
INCREASING INVESTMENT RETURNS
The difference between the good investment and the great investment is the appreciation rate, with the superior property appreciating faster than the average property. We will attempt to compound investment funds at 10% to 20% per year using a combination of the following 2 methods:
1. Rent Increases:
Basically, we are looking for buildings that have not maximized their rent potential. Apartment buildings are priced based on the rent multiplier: for each rental dollar collected in a year the apartment sells for 8 times, 9 times, 10 times that amount. If we increase the rent on one unit $100.00 per month x 12 months equals $1,200 dollars a year, times a 10 multiplier, we have increased our equity $12,000. This can happen in one month or 5 years depending on the building.
2. The 1031 Exchange option:
The IRS gives a special tax break to real estate transactions: the 1031 Tax Deferred Exchange. Essentially, if you sell an apartment building and buy another apartment building, you pay no tax on the gain. This gives us the ability to roll our gains into ever-larger projects without losing 30% or more in taxes on each rollover.