How Does An Investor Actually Make Money From Real Estate
Have you hear about people complaining that real estate yield is low. At times, even if owners are renting out their property, they still have to come up with additional capital to pay for the mortgage. All this negativity and still there are people investing in real estate? Are they straight in their mind? Can a layman invest in real estate? Is real estate like stocks? What is the secret to it?
The Secret Is All In The Numbers
When you take a loan for a real estate, you will need to pay for your mortgage. Breaking down the mortgage, you have two components in the monthly payment. First is the Interest and second is the Principal payment.
The interest payment does not add on to the value of your property. In fact, it is the money that the bank is earning from you because they provide you with a loan. This portion has nothing to do with your earnings.
The Principal payment is the IMPORTANT part which makes you the hidden money. Many people do not know that when principal payments are made it reduces the loan balance. Although you do not see the money, it is actually your money. You are earning, just that the money is being kept in the property. A more proper term would be a gain in equity.
Misconception With Many Home Owners
What if you bought an investment property, you have a tenant and you still have to come out with money every month to service your loan. Many owners would have already come to a conclusion that this is a bad investment. What would an investor think? Let me ask you, when you invest in something, is it for free? Does an investment mean that you must not come up with any money? I think the determining factor of a good or bad investment is finding out how much return you get at the end of the day. That is a more accurate way, rather than judging from the surface if you need to come up with money or not.
How Are You Earning Money?
As mentioned above when you pay your principal payment you are actually earning money. Simply put, as long as your tenant’s rent is more than the interest being paid to the bank you are earning money. A simpler and correct way to understand is, how much is the tenant helping you to pay for your property? Your tenant is actually co-paying your property with you. Let me give you a few examples below.
In Example A, we can see that the tenant is paying for all the monthly mortgage does it means that you earn nothing? No! You earn an equity of $1,400 as the principal payment reduced the loan balance. The interest is a payment to the bank.
In Example B, we will need to come up with an additional $500 from our pocket. Are we losing money? No! The $500 you come up with is actually under forced savings method. You are actually putting money in the property and the money is still yours. Taking away the interest of $1,600 from the rental income your tenant actually helped you to pay $2500, and you earned $900. You used your tenant’s money, your rental income, to increase your equity in the property.
This is the most ideal situation where the rental income is greater than the monthly payment. This means that you are getting back passive cash returns of $500. Similar to Example A $1,400 will be the increase of your equity to the property. You are not coming up with any cash monthly, you increase your equity assets of $1,400 and at the same time get back cash returns of $500.
So what do all these means? Remember I mentioned to calculate returns? Let’s do it now!
Note: Interest and principal payments are not equal throughout the loan term. Interest will decrease gradually, while principal repayment will increase gradually. If you want to know more you can check out my post about the basics of a mortgage.
Case Study: How Much Will You Earn After 10 Years?
We will use an example of a property worth $1 Million taking an 80% loan, with 3.5% interest.
We will first need to calculate how much loan balance is left after 10 years. We can then minus the selling price with the loan balance to see how much money is actually equity(our money). Calculating, the loan balance is $435,876.36. What is the cash proceeds?
Stagnant Selling Price
We assume selling price never increase at all. Cash proceeds = $1,000,000 – $435,876.36 = $564,123.64.
Your earning is by deducting the cash proceeds from your investment capital, the money you have come up with. Every month you top up $471.73 cash. When you purchased the property, your downpayment is $200,000. Earnings = $564,123.64 – ($471.73 x 10 x 12) – $200,000 = $307,516.04
Hey, over the course of 10 years, you earned $307,516.04. Is it a lot? Ask yourself if you have saved up $300,000 over the course of 10 years. Have you had any investment that provides you with a $300,000 return over the course of 10 years? For an investor by using discounted cash flow method calculation, your IRR is actually 8.67%!
What If The Property Appreciates?
Your returns will be much much more! Let’s assume that your property appreciates by $200K. You IRR will actually be 11.93%. This means that your annualised return is 11.93%. In terms of quantum, after 10 years, you have a cash amount of $764,123.64!
Real Estate Investment Secrets
The money is earned when you used the tenant money to pay for your property. Most people only value if they can get back cash monthly but forget that even if they do not get back any cash the property is accumulating wealth. When you take a loan, you do not need to come up with a lot of cash and you make use of leverage to increase your earnings. Price appreciation of a property is also very important to increase earnings. Let me help you to make a detailed financial planning and build your wealth through real estate now.