This whole idea of LEVERAGE is great and earning $81,000 on a $20,000 investment over seven years would be terrific. The problem with this is “IT’S STILL TOO SLOW.” We can still do much better. Besides leverage, we need to add the principle of VELOCITY. Here’s how it works:
Now, you may now be thinking that this whole idea of leverage is great and earning $81,000 on a $20,000 investment over seven years would be terrific. The problem with this is “IT’S STILL TOO SLOW.” We can still do much better. Besides leverage, we need to add the principle of VELOCITY. Here’s how it works:
In the first year, the investor takes the $20,000 and buys the same $200,000 home as previously illustrated in The Fast Track to Financial Freedom (Part 1) – Leveraging your Money. The home still appreciates at 5% each year and the rent on the home covers the expenses of owning the home, including the mortgage payment.
After two years, this home will be worth approximately $220,000. Instead of letting that appreciation sit and accumulate, the investor borrows it out and buys another $200,000 home. How is this possible? Quite simply, the investor puts a second mortgage on the home in an amount equal to the appreciation.
The rent is raised just enough to cover the interest on this additional loan. (Most landlords raise the rent at least every two years.)
The second home also is rented out and appreciates at 5% per year. Every two years, the appreciation for each home the investor owns is borrowed out and used to buy new homes.
By doing this, at the end of seven years, the investor will own eight homes with a total value of $2,020,000 and equity of $273,000. This is compared to equity of only $101,000 if the investor only bought the first home and compared to equity of $39,000 if the investor had relied on the compound interest from mutual funds. This is what we call VELOCITY.
The velocity of money is simply the process of continually moving money into new and better investments.
At a net equity of $273,000, the investor has more than thirteen times their original investment in seven years. This is so much better than the compound interest that most people have a difficult time believing it.
When I do this demonstration in a seminar, there is always at least one person who will not believe it is possible. At that point, I ask the audience if anyone has ever put the concepts of leverage and velocity into practice. Invariably, someone raises their hand and explains that in actual practice, it has worked much faster than what I have demonstrated, because of the very conservative nature of this demonstration.
You probably would be thrilled with this level of returns. Our clients at ProVision would be disappointed in a value of ONLY $2 million at the end of seven years from a $20,000 investment. Why? Because this return does not factor in any of the tax benefits from investing. Tax benefits, when properly taken, CAN DOUBLE YOUR INVESTMENT.
Let’s go back to our example. Suppose our investor is in a combined federal and state tax bracket of 35%. Suppose also that our investor has excellent tax advisors, like those at ProVision, who understand the MAGIC OF DEPRECIATION.
Depreciation, quite simply, is a non-cash deduction each year for a portion of the purchase price of the rental real estate. This deduction will put a considerable amount of money back into the pocket of the investor.
Suppose that the investor takes the tax savings from the depreciation and uses it to purchase additional single-family homes. And just like the other homes, every two years, the investor borrows out the appreciation and buys another home.
At 10% down and 5% annual appreciation, with just the original $20,000 investment and the tax savings from depreciation, at the end of seven years, the investor will own the following:
– 16 homes with a total value of $4,200,000
– Net equity of $540,000, or roughly double the net equity of $273,000 without the tax benefits
– Annual appreciation after seven years of $210,000 per year
– All with a single initial investment of $20,000
So let’s recap. If the investor had listened to a typical financial advisor, the investor would have invested $20,000 in a mutual fund and, with a very good market, would have $39,000 at the end of seven years. On the other hand, if the investor had used the concepts of leverage and velocity, including tax benefits, the investor would have $540,000 at the end of seven years and a portfolio worth over $4 million.
What’s amazing about the concepts of leverage and velocity is that they are not limited to real estate. They work equally well in business and in the stock market. But if these concepts are so great, why doesn’t the average investor use them?
The answer is simply, KNOWLEDGE AND EFFORT.
There is one final factor – EFFORT. It is easy to give your money to an investment advisor and it is easy for the advisor to put the money in a mutual fund. It is not nearly as easy to gain the knowledge necessary to put the concepts of leverage and velocity to work in real estate, business, or the stock market.
It takes effort, both from the investor AND from the investor’s advisors.
ABOUT THE AUTHOR: Tom Wheelwright is not only the founder and CEO of Provision, but he is the creative force behind Provision Wealth Strategists. In addition to his management responsibilities, Tom likes to coach clients on wealth, business, and tax strategies.