If you were to ask your local bank manager how 'compounding money' works, he/she would say this: deposit $100.00 in a savings account here at the prevailing interest rate. After 1 year, the principle and interest earned are added together. At the end of year 2, interest is earned on both your combined principle and interest from year one. If you make no withdrawals for the next 20 years, your initial principle of $100.00 will have compounded into a much larger sum.

My question here is simple: how is compounding used in the real estate investment world?

There are way too many variables to really have a cut and dry answer to this. You can have rents go up and property values go down. You can have property values go up and rents go down. You could have stagnation on both.

Increasing rent yearly on a single-family home is not necessarily going to affect the overall appreciation on that property at all. On the other hand, buying a multi unit at significant discount, you could increase the value of a multi unit in one year with good management and increasing rents. Which I understand to be forced appreciation.

NE,

google future value of an annuity due.

Hi Roy,

I find this useful in working up returns. You can change rate increase to fit your market.

www.calculator.net/rental-property-calculator

Does appreciation and compounding interest go hand in hand Roy?

I think this might be a hypothetical question.

What happens to that $500 monthly cash for if you have to replace the roof? You could run a negative for the year. Where's your compounding interest then?

I've never looked at a piece of real estate and tried to figure out the long term compounding interest. I've looked at immediate cash flow. Instant equity at purchase. Equity after repairs for resale value. Potential increased rents with better management. Increased cash flow by managing expenses.

I'll answer simply: no investment other than the hypothetical situation you proposed has truly compounded returns. Where earnings earn more earnings in the future, onward and ever upward.

But we've been tricked. Investing advisors often send out brochures showing the effects of "compound interest" investing $X per month in an IRA, but that isn't what happens in reality. Think about this logically for a moment.

To have true compounding, your gain from year 1 must be LOCKED IN FOREVER. If any of the original principle or any of the gain is ever lost, then true compounding goes out the window because those lost earnings are no longer earning more earnings.

Stocks rise and fall. So do real estate rents and values. They do not compound, other than possibly for a short period what happens looks like compounding. But when rents and values fall, compounding no longer works.

Example: I may experience what looks like short-term compounding with something like my automatic 2.9% rent increase that is 2.9% lager than last year (which is 2.9% larger than 2 years ago, etc). But if/when rents peak and the economy will no longer support those rents, I may have to discount them to get back to where they are affordable. I may have to sell that house that was $60,000 last year for $50,000 this year. Thus, I lose my "compounding" effect.

What you're thinking of, and what truly applies to stocks, real estate, etc. is ANNUALIZED (yearly) returns. You figure out what your return was for last year and compare it to this year's return. That gives you a true measure of where you are and how you did.

One way you can kinda sorta get compounding is if, let's pretend, you lock in some of those rent gains and redeploy them to earn more rent. You buy a house, and the profits from the rents add up and allow you to buy a second house that now generates twice as much rent. The rent value was locked in when you took it home as profit, and the compounding is realized when you redeploy those earnings to generate more earning (2 houses = 2 x the rent). But you still run the risk of the investments losing value. Ask anyone who bought a house in 2007 how compounding worked out by 2010.

Another way is if you use 'DRIPS' so that dividends issued from stock is used to buy more stocks. At that point, you lock in the gain because where you once owned 1000 shares, the dividends were used to buy 10 more shares. You have now "compounded" your return by 1%. Woo-hoo! But if the value of the stocks plunges 10% and you have to sell....well, you just lost your "compounding."

If/when interest rates on bank CDs get back to 10%, we can get excited about compound interest/earnings.

Btw, I should have summarized: compounded returns are only possible when you have two factors...

1) There is always a positive return from the previous year.

2) The value of the investment can never fall below what it was at the end of the previous year.

So if I have a $10,000 CD at 8% interest, here's what happens.

Year 1: I earn $800. I now have $10,800. I will never have less than $10,800 as long as I don't touch the investment.

Year 2: I stared with $10,800 and earn $864 more. I now have $11,664. I will never have less than $11,664 as long as I don't touch the investment.

That scenario is unique to currency denominated assets with a 'floor' below which they cannot fall, and that 'floor' is the value that was locked in during the previous year. That simply doesn't apply to real estate, stocks, bonds, etc. that do rise and fall over time.

NE,

I am trying to make things simple here. Lets assume you have $500.00 in net rent each month. In addition, you want to re-invest (or compound) that $500 (each month) for the long term. How do you do this?

1. Put it in the bank at 1% interest?

2. Put it in your 401K?

3. Buy more real estate?

5. Pay off your high interest rate credit cards?

6. What else?

Thank-you Sid. I knew you would give the best answer to this.

Roy, the "best" answer will be different for each person depending on life goals...but based on what I know of you and your goals and talents I see two "best" options.

#1) Get DEBT FREE so that the payment you are sending your bank each week ends up in your pocket instead of theirs. Each time you pay off an additional $1 of principle, you "lock in" the gain of future interest not paid.

Example: You have a mortgage at 5% APR. If you take $500 each month (x 12), that is $6000 of additional principle paid annually. That saves you $300 of interest each year that you hold onto your note. That gain (expense loss) is fully realized today and is never taken away. True you will lose a small interest deduction on your taxes, but we're trying to keep this simple.

Reason for #1: I've heard you say you want paid off rentals, too, which is why I recommend this route as the #1 best choice. You also lock in the 'gain' of less risk.

#2) - Use $500 to buy an option on a piece of real estate that you secure for pennies on the dollar using your super-negotiation tactics and sell you option to a flipper for a $4000 - $5000 profit. Rinse and repeat. That would compound the your initial investment nicely!

The main problem with scenario 2 when evaluating this as an investment strategy is that we are not factoring in the value of time and effort it takes to find, negotiate, list, and sell a property. The costs for that should be paid out as a salary or commission to someone....you, if you do all the work. Then the profit AFTER that payout would be the true measure of your compounding rate.

Paying off debt takes little to no time other than clicking a button and keying a few extra principle payments, and is therefore negligible.

Deal and money velocity is another consideration. How many $5000 "Roy specials" can you find, purchase, list, and sell if you focus the majority of your time on this strategy? No rehabs, no fixers, minimal time spent land lording....90% of your day is just finding, buying, selling, rinse, repeat over and over. How many units do you think it would take to max out this strategy? Could you turn 3-5 units a month? If so, you will make far more money doing this than land lording. But you will work much more vs. buying more houses and letting them slowly bring in cash over the years.

It's a win either way, but with different amounts and types of input. As a wise teacher told me once, one of the most important things you can spend your time doing at the beginning is decide what do you want to be when you grow up. (*grins)

Thanks again Sid,...Based on your expert advice here, that same advice would have cost me $250.00/hour if it had come from my CPA who is a licensed financial planner.

Will you settle for a case of PBR? Remember Room 602 at the Renaissance hotel in St. Louis? Or was that Indianapolis?

As an Engineering grad, I used TVM (time value of money) formulas a lot.

Sid,

Sounds like your getting compounding and leveraging mixed up.

You could never compound enough of any investment to compare to leveraging the same amount of money in rental invesment. Just one BK by tenant or major investment event like hole in the roof or uncovered damage that insurance WON'T cover. your compounding is shot to hell.

To my thinking this is exactly where investors go wrong. They lose sight of the target and start thing that grass is so much greener over there.

Myob,

NE,

Roy investors went belly up cause they didn't roll that leverage. You have to keep working leverage in RE. Refinancing is one big way.

When I brought all my VA homes most were leveraged at least 95%. I had to put 5% down. (yes some were 100% financing).

My deal was: what every property's I purchased my realtor would keep 1K. He would give me back anything over that 1K.

This allowed us to cover the next purchase and some fix up. We did that for 8 to 10 years.

We then took 25 of the first VA foreclosures we had purchased, that were well seasoned, and refied them for 85 to 90% of their value with WAMU @ about 2%.

So we dumped the old 6 to 8% loans and cashed out 25. We took the proceeds of those 25 and paid off 25 with low balances and high interest. We sold one of the WAMU so that left us with 24.

Myob,

What you describe there with leverage is what only the most experienced investors would do. That is like standing at a Las Vegas crap table with a Bible in one hand and rolling the dice with the other,..LOL.

Financed with 100% leverage of what? Current value, ARV? Offer price if buying 10 cents on the dollar?

Most of my after rehab financing on rentals is between 20-40% of the actual value. That's not 100%. Who cares?

Roy your missing one or two points.

I had NOTHING IN THESE PROPERTY'S. They were 95-100% financing. What did I have at risk to accumulate these 80 property's? Second we did consume every penny were where making back then-- to buy the next one and the next one.

COMPoUNDING AND LEVERAGING ALL IN ONE!!!!

"You'll never have a comfortable life without RISK as a RE investor".

I would agree with that statement. Every fixer-upper junky trashed-out house I have ever bought had RISK written all over it. However, the way I minimized my risk was by using leverage conservatively and not getting into a financial debt hole so deep that I could not get out of it.

Roy I can tell you why if your interested? They never treated it like a business. This is what I mean by business.

I worked 2nd shift-- even though I could hold days. WHY? I would get up at 7am-- bring my work cloths to the job site and at 2pm -- my wife --= who was there beside me-- would say time to get ready for work. I would shower at the new investment and go to work. Get off at 1130PM head home and next day do the same thing. My off days and vacation days were spent buying and working on rentals until we had 80 of them. Roy when I had lunch and break times -- my fellow mechanics would laugh and ridicule me and my "get rich" schemes. When I left at 50 yrs old on my Leave of Absence my fellow mech's acknowledged by saying-- well we see who's laughing now.

When I pulled up in front of the VP of maintenance he came over and said -- we must be paying these mechanics way to much. TRUE story. In my new "Prowler"

Out of 21 persons we know who thought this was get rich quick-- my wife and I were the only ones left. THEY GAVE UP ROY. They wanted it right now-- not 20 years from now.

So I laugh when I hear folks say "we just couldn't do it". THEY DIDN'T HAVE WHAT IT TAKES-- THATS WHY THEY FAILED.

To my thinking over 50% of the folks here have what it takes-- some deviate from course and that never works.

Myob,

Roy maybe someday we'll meet. Ol Carlton Sheets-- now that's a name outta the past. Had a great TV pitch didn't he?

We were "Al Lowery" to start-- took his seminar (3 days weekend) first. Remember his news paper ad about March 1986 where he was doing seminars in April and we took a weekend class.

I still remember Al had a 5.25 floppy disk to help you evaluate an investment-- or ROI I should say. He also had a cassette tape called the "blue vase" which I listened to all the time.

Myob,

Optimally you would choose the highest expected return investment to deploy your $500 into. That simple.

Optimally you would choose the highest expected return investment to deploy your $500 into. That simple.