How Compounding Works in Real Estate Investing
August 5, 2022
Savings accounts aren't the only way to earn compounding interest. For example, real estate investors earn compounding interest when focusing on property appreciation, reinvesting rental income, and cash flow.
According to Albert Einstein, compound interest is the eighth wonder of the world, so let's see how compounding works in real estate investing to see if it's right for you.
Compounding in Real Estate
Compounding in real estate is just like compounding in any other investment. You use the money earned from one real estate investment to invest in another. Putting your money to work for you increases your earnings without investing your own capital.
What Is Compounding
Compounding occurs when you earn profits on the money you invested plus the money earned. The simplest form of compound interest is on a savings account.
Here's an example. If you open a savings account with $5,000 and earn 1% interest, you'd earn $50.23 in interest the first year.
But, if you leave the money in the savings account for five more years, your $50.23 in interest compounds, earning you an additional $258.82 in interest, for a total of $309.05. If you didn't earn compound interest, you'd earn only $50 a year, or $300 total.
That is a simplified example. Now, let's look at how compounding works in real estate investing.
Compound Real Estate Investing Strategy Example
To see how compounding works, real estate investors must continue buying property using the equity from current rental properties and their own capital. Here's an example of an investment strategy using compounding interest in real estate investing.
Let's say you buy a property for $150,000. You pay all cash for it. You have a net cash flow of $6,000. For this example, we'll assume cash flow, expenses, and rental income remains the same. We'll also assume property appreciation is a steady 6% per year.
You'd earn $50,730 in appreciation and have a net cash flow of $30,000.
If you use some of the home's equity plus your own money to buy another property for $200,000 and have an annual cash flow of $4,000, you'd have a total cash flow of $34,000 and properties valuing $350,000.
In year 10, you'd earn an additional $67,645 in appreciation on the second home and an additional $67,900 in appreciation on the first home for a total property value of $536,275 and an annual net cash flow of $
over the next five years and have a net cash flow of $47,645 plus the appreciation on your original property of $67,900 and net cash flow of $60,000 on the first home and $20,000 on the second home for a total cash flow of $80,000.
If you continue reinvesting the rental income and capital appreciation, you can continue increasing your capital growth and monthly cash flow.
Considerations for Compounding Real Estate
Compounding real estate doesn't work as fast or as simple as savings account interest. Here are some factors to consider as you grow your real estate business.
- Appreciation isn't guaranteed
- Homes may appreciate wildly one year and the subsequent year slow down or even decline. There's no guarantee a home's value will increase. While it's a common trend, there are unavoidable downtimes, such as the housing crisis of 2007 - 2008.
- Vacancies happen
- Don't assume you'll have 100% occupancy because no real estate investor does. Account for the average vacancy rate in your area, but also plan for the worst. Unexpected vacancies can decrease your compound interest earnings because of the higher costs they cause.
- Unexpected repairs occur
- Real estate investors must handle all maintenance and repairs. While you might create a budget that allows for regular maintenance and repairs, what happens when there's a crisis, and you must spend more on the repairs?
- You may need your own funds to buy properties.
- To compound your earnings, you may need to dig into your own capital to grow your real estate portfolio. If your properties aren't appreciating as anticipated or your cash flow is lower, you may not have the equity needed to buy another property.
How Compounding Works in Real Estate Investing
The simplest way real estate investors earn compounding in real estate is in appreciation. When you buy and hold properties, you continually increase your capital growth. For example, if you bought a home for $200,000 and it appreciated 5% a year, you'd earn $31,525 in three years, but if you hold onto the property for ten years, you will earn $125,778 in 10 years.
Another way real estate investors earn compound interest on rental properties is by reinvesting the rental income earned on rental properties. For example, let's say you make $25,000 in net cash flow on a property, and rather than spending the money, you use it to invest in another property. As a result, you now have another investment earning rental income and capital appreciation to compound your earnings.
Compounding and Real Estate Investing Tips
As we said, compounding in real estate investing isn't as simple as the compound interest you earn on a bank account. Here are some tips to keep you on track.
This isn't a 'go big or go home strategy. The smaller you start, the easier it is to understand real estate investing, potential profit, property management, and capital gains taxes. Remember, your goal is to buy and hold, not buy and sell fast. Owning a property with a mortgage payment you can afford and holding costs that won't break your budget if there's a vacancy gets you off on the right foot.
As you gain experience and want to increase your real estate wealth, you can buy more than one property and enjoy exponential growth.
Like any investment, the earlier you invest, the more time there is for your earnings to compound. Combining this tip with the tip to start small, you're more likely to be able to afford a rental property sooner than you think.
The longer you hold onto the property, the more growth you'll earn. In addition, you'll earn more rental income by keeping the property.
Don't spend the money earned on a rental property. Instead, use it to reinvest in another property. Property owners who own multiple properties often hire a property management company to handle the home's maintenance, repairs, and tenants to reduce the stress on the property owner.
Like any investment, there are risks when you invest in real estate for the compounding. Here's what to consider.
Like we said above, there are no guarantees properties will appreciate. Do your research and invest in an area that historically appreciates. If your investing strategy is to buy and hold, you want a home that will appreciate annually, compounding your earnings.
There's also the risk of not finding renters. So, again, it's essential that you do your research and invest only in areas with high rental demand. With property prices increasing today, real estate investors can capitalize on the higher rental demand because many consumers can't afford to buy a home.
Finally, you should keep an eye on your expenses. The costs to run a rental property reduce your profits and, eventually, the potential compounded earnings. The less you earn on a property each year, the less you'll make over the long term.
Other Real Estate Strategies
Compounding real estate investors bank on the property's appreciation. However, if that's not a gamble you're willing to take, you should consider other real estate strategies.
Cash Flow Strategy
The cash flow strategy focuses only on the monthly rent earned minus operating expenses and mortgage payments. So, instead of focusing on property appreciation, this strategy focuses on how much you make each month.
Capital Growth Strategy
The capital growth strategy focuses on a property's appreciation, not its monthly income. Whereas the compound growth strategy focuses on both factors, the capital growth strategy focuses on appreciation only.
Many properties in this strategy have a mediocre or negative cash flow. As a result, investors buy and hold for a shorter period, usually 3 - 5 years, focusing on the profit they'll earn and not how they'll reinvest it.
What Does Compounding Mean in Real Estate: FAQ
What Is the Compound Investment Formula?
The compound investment formula uses the principal amount (p), interest rate (r), frequency of compounding (n), and timeline (t).
Here's the formula:
A = P (1+r/n)^(n*t)
Does Compounding Really Work in Real Estate?
Compounding in real estate means you take the earnings from an investment property and reinvest them in another property to earn even more money.
What Is Compound Growth Rate in Real Estate?
The compound annual growth rate (CAGR) is an investment's growth rate if it grows at the same rate every year and the earnings are continually reinvested.
Understanding Real Estate Compounding: The Bottom Line
The more investments you have that compound your earnings, the more wealth you'll have in the long term. Understanding how compounding works in real estate investing can help you continue to reach your financial goals and real estate wealth. Learn more by signing up and visiting our blog.
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