Wealth Creation, part 2: Real Estate as a meaningful component of your portfolio

Why is it good to have Real Estate as a part of your portfolio?

There are several reasons, but the main differentiator between real estate and other investments is Leverage.  What is leverage?  It's also called Other People's Money (OPM) and probably other things.  Leverage is buying an asset by putting a small (or large) fraction of the money down yourself, and borrowing the rest.  This means that not only is your money working for you but other people's money is working for you too.
When you invest in the stock market, your money is working for you, and you'll see increases of 8, 10, maybe even 12% per year on your initial investment.  In real estate, you put a down payment (the standard is 20%, but I've bought houses before with as little as 3% down (although this is harder today than it used to be).

Let me give you an example:

I have $10,000 to invest.  I can do one of two things with it.

1) I buy a Dow Jones Industrial index fund with my $10,000.  The stock market has an exceptionally good year and increases 15%, and I end up next December with $11,500.  My return on investment is $1,500/$10k = 15%.

2) I use my $10,000 as a down payment on a $50,000 house.  I borrow the other $40,000 from the bank (OPM).  In the next year, the house appreciates 5% (a realistic appreciation historically) and the house is worth $52,500.  I still owe $40k (well, probably more like $39,500 because I've paid down a little bit of principal).  So my equity (defined as the value of the house minus the mortgage) is $52.5k - $39.5k = $13k.  So my Return on Investment is $3k/$10k = 30%, twice the return of the optimistic stock in the example above.

One could get even more aggressive, and take the $10k and split it and buy 2 houses, with $5k (10%) down each.  If each of the houses increased by 5% to $52, 500, the total would be $105k.  So your return on investment would be $5k/$10k = 50%!  The more leveraged you are, the better the return.

To be completely transparent, leverage can work against you too (as it did with many people in the last year of economic downturn) if the value of the house went down 10% from $50k to $45k in example 2, you would have lost half of your down payment, and you would be down from $10k equity to $5k, or a 50% (unrealized) loss.  So what do you do if this happens?  Nothing!  Real Estate has gone up over any 5 year period over the last 100 years.  So you should just keep collecting rent, keep making your mortgage payments and wait it out.

Next post: What is cash flow?

The Rule of 72 and Intention-Manifestation

I'm going to talk about one widely accepted mathematical truism and one crazy non-fact-based idea in this post.

First, the Rule of 72.  Once you have started to track your net worth, you need to figure out how fast it's growing and whether that's fast enough.  One way to understand the speed at which it is growing is to use the Rule of 72.  It says that if you start with 72 and divide it by the annual growth rate (in percent) that you're growing, this will tell you how long it will take (in years) to double your net worth.  So for example, if your net worth is growing at 6%/year, it will take 12 years to double your net worth.  At 10%/year, it will take just over 7 years.  And so on.  This is an approximation that works at low fractions, so as you get to bigger growth rates it is less accurate.  So if you want to double your net worth in 3 years, you will have to grow at 26% (rather than the expected 24%).  And this compounds...so that if you are growing at 12%, it will take 6 years to double, and another 6 years to double again.  So in 12 years, you will have quadrupled your net worth.
Exercise: Get out your calculator or excel spreadsheet and figure out how fast are you growing and how long it will be til you can retire.  There are other variables to take into account to determine retirement age, but you can take a swag at it using a 4-5% fixed income rate of return once you retire.  So if you have a net worth of $1M, you would be able to earn $40-50k/year from that.

The second exercise I think is a little nutso, but it doesn't cost much.  Many, many books on wealth creation and other things say that the first thing that you should do is write down your goals.  This will help you achieve them (This is called the intention-manifestation model, but I'm not going to dive too deep into that here).  Choose how much you want to grow the net worth in the next year, three years and five years.  Even starting with one year is a good place to start.  I decided that my goal is to double my net worth every 3 years.  I have a little post it note widget in the corner of my screen which says Grow Net Worth by 26% in 2010, from xx to yy.  I then calculated whether this was realistic.  I used a simple rate of 7% appreciation in the Seattle real estate market and a 10% appreciation in the stock market (these are not super-ambitious numbers, but not super-conservative either).  So I ended up with four areas of net worth growth.

Real estate appreciation
Stock/mutual fund appreciation
Loan pay down
Surplus added to my investments

Real Estate Appreciation: The important thing to remember about this number is you take the appreciation based on the total asset, NOT based on the equity in the house.  So let's say I have a house worth $500k and a mortgage of $400k.  My equity (which is added into my net worth) is $100k.  But when I calculate my 7% increase in the value of my house, it's 7% of $500k = $35k.  So while the property only gained 7%, the net worth increase of the real estate part of my portfolio is 35%.  This is what "leverage" is all about.  The more leveraged you are (leverage = property value/equity), the more an increase will effect your net worth.   I should also note that the same is true for a decrease.  The more leverage you are, the more trouble you could get into if the property value decreases (which we saw in 2008-2009).  80% Loan to Value = 5x leverage.  90% LtV = 10x leverage.  One of the challenging things about this is that as your property value increases, your LtV decreases and your leverage decreases.  So you need to monitor this value over time.  I should talk about that separately.

Stock/mutual fund appreciation:  This is not leveraged, so just take your total amount invested in the market, and multiply it by 10% (historic appreciation of the dow over 10 year time period) to calculate the increase.  You could make a more sophisticated formula, but it's probably worthwhile to keep it simple.

Loan pay down: Look at your last mortgage statement and see how much principal you paid last month.  Multiply that by 12 and it will tell you roughly how much principal you will pay down this year.  In general this is << the change you'll see due to Real Estate Appreciation, at least for the first fifteen years or so of the loan.  Each year it gets a little bigger though.

Surplus added: This is the money you are left with after all the bills are paid each month that you can invest for the long term.  You can increase this by doing a "cost out" exercise (see previous post) or by investing your bonus or other non-periodic income such as stock options which vest quarterly, and living on your monthly income.  The cost out exercise is what's sometimes known as "the latte factor" or by other names.

If you add these four things up and find you're light to your goal, you should try to figure out what you can do to increase one or the other.  Can you take some cost out of your everyday life and add that to your surplus?  Do you need to add some higher-growing real estate to your portfolio?  Can you pay a little extra down on your mortgage or credit card bills?

That reminds me.  When I said Loan pay down, I should have included other debt besides mortgage -- credit card debt (that's the worst), auto debt, etc etc.  Credit card companies are and credit card debt is evil.  Before doing any of this other stuff, make sure and pay down your credit card debt!  This deserves a whole separate post.