THE FORMULA:  “Why real estate is the way to make your fortune”

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 the U.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

COMPOUND INTEREST $1,000 turns into $33,000 in 50 years. Here’s how it works:  Interest is added to principal, the interest is then calculated on the new amount. Example: $1,000 + 7% interest = $1,070. Interest year two is 7% on $1,070 or $75, and on and on.  If you invest $1,000 simple interest in fifty years you have $4,500. With compound interest you have $33,000. Einstein called compound interest the greatest mathematical discovery of all time!

PUTTING IT TOGETHER

Purchase an apartment building with an annual rental income of $125,000. Price:  $1,000,000, or 8 times the annual gross rental income. Make a 25% ($250,000) down payment. Increase the rents 4%, or $5,000. Multiply the $5,000 rent increase by the 8 annual gross rent multiplier = $40,000 increase in equity. This represents a 16% return on your down payment, without considering cash dividends, loan principal reduction and tax advantages. Compound this 4% rent increase for 5 to 6 years and your $1,000,000 building is now worth roughly $1,250,000. You have doubled your down payment in 5 years by increasing rents only 4% per year, and further secured your Trust Deed position.

 Annual rental     Annual rental                 Building           Down         Equity % return
     income         income multiplier              value           payment         down payment

  $125,000                   8                      $1,000,000      $250,000             Year #1

  $130,000                   8                      $1,040,000      $250,000      / $40,000 = 16%

  $135,200                   8                      $1,081,000      $250,000      / $41,000 = 17%
  $140,608                   8                      $1,124,864      $250,000      / $43,864  = 18%

  $146,232                   8                      $1,169,858      $250,000      / $44,994  = 18%

  $152,081                   8                      $1,216.655      $250,000      / $46,797  = 19%

  $158,164                   8                      $1,265,313      $250,000      / $48,648  = 19%

The big advantage of owning real estate is to take advantage 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. Conversely, if you divide the number of years in which you wish your investment to double into 72, you get the required compound rate of return. Keep in mind, you are using leverage in your purchase, so; the doubling your down payment happens quite a bit sooner than doubling your entire investment. Keep in mind inflation plays a part in your return. Click here for an inflation calculator courtesy of the Minneapolis Federal reserve bank.

FOR EXAMPLE: You buy an apartment building today for $600,000, ($150,000 down & a $450,000 loan), and you forecast a 07% appreciation rate. The Rule of 72 says:  72  divided by 7% return equals approximately 10 years to double.  Ten years hence, you refinance your $1,200,000 building using a 75% Loan to Value Ratio=$900,000 new loan. You pay off your old loan and have $450,000 cash-out proceeds to buy an additional $1,800,000 of apartment buildings (25% down). You now own a total of $3,000,000 worth of apartment buildings, your net worth is $750,000, and you are only 10 years older than today!

Leap forward 10 more years, 20 years from today: Your buildings are now worth $6,000,000. You re-finance and employ the $2,250,000 cash-out proceeds (75% LTV), and buy $9,000,000 of new buildings. You now own $15,000,000 of apartment buildings ($6,000,000 plus $9,000,000). You have turned $150,000 into $3,750,000 in equity and $15,000,000 worth of real estate in 20 years! What are you waiting for?

To see the results of successful compounding, read this brief paragraph from Warren Buffett’s book: “Of Permanent Value”

Buffett Partnership letter, January 1965
The joys of compounding: “One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to the notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24.00 net. For this, Minuit received 22.3 square miles, which works out to about 621,888,320 square feet.  While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seem reasonable given a current land value for the island of $12,433,766,400 ($12 ½ billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6½% return (the tribal mutual fund representative would have promised this them this) to obtain the last laugh on Minuit. At 6 ½%, $24 becomes $42,105,772,800 (42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get 7%, the present value becomes $205 billion.”  One half percent extra appreciation per year is the difference between $42 billion and $205 billion!