Equity and Appreciation of the Real Estate Investment Portfolio (Pro Forma Parts 3 and 4)
5 Key Aspects to Evaluating Real Estate Investment Properties Pro-Forma (Part 3 and 4) Over the years I have learned so much about equity and appreciation of a real estate investment. The key thing I came to understand is that many people believe equity and appreciation to be the same. This is why I wanted to put these two parts of the pro forma together into one so we can look at the benefits of them both and how they are indeed different.
There are Two Very Distinctly Different Ways to Build Equity
1. Equity buildup byway of debt reduction.
The typical investor will buy an investment property with a mortgage. Each month the tenant makes a mortgage payment to you the landlord, you in turn use part of the rent payment to pay the mortgage. Let’s assume for this conversation that $300 of that mortgage went to pay down the principle of the loan. This $300 dollars each month that pays down the loan goes into building up the equity you now have in the property. Let’s say the original loan was for $100K and now has a balance of $99,700. At the end of a full calendar year that is (12) $300 debt reductions payments totaling $3,600 per year in equity buildup. This is money that is silently being added to your net worth.
2. Appreciation as a property appreciates in value.
The national average for the past 50 years has been a 6% annualized appreciation. On this same $100k example, the appreciation would generate you $6,000 ($100K x 6% = $6,000. This is also money that is silently adding to your net worth.
Combining these two benefits together you realize a total of ($3,600 + $6,000-$8,600) in (Silent) wealth building.
Your Considerations Will Maximize Your ROI On Your Real Estate Investment
There are many who will suggest you only want to look at the cash flow to judge whether or not you will make a purchase. I totally agree that the cash flow is the paramount decision maker as to whether or not the purchase will be a good investment. If you do not have cash flow you do not want to buy, period.
You do however want to also consider that when you identify cash flow you also have these other forces at work for you. The tax benefits mentioned in the previous post and the equity buildup and appreciation identified here are also wealth building principles working silently in the background that you definitely want to understand.
Appreciation is something that no one can promise you and therefore many suggest you should simply judge a property for the cash flow and use any growth as an added benefit should you realize the value growth. While I understand the premises to this, I do not totally agree with that. I believe it needs to be a consideration when investing.
You do not want the appreciation to be the deciding factor however appreciation is the largest of the wealth building principles. Look at the example above. The appreciation is larger than the equity build up, larger than the tax benefit and most often even larger than the positive cash flow. So with such a large wealth building principle at play, I believe your best investments are the ones you put a lot of strategic emphasis on finding investment properties in areas that are poised for growth.
When you do not put any focus on the appreciation you are too easily lured into just buying any old property that cash flows. I can assure you from years of experience the seasoned investors who win big are factoring all these wealth building principles into their decision making process.
Next post we’ll look at the leverage of the real estate investment portfolio.