Many investors are plagued by contradictory behavior where they adopt a pro-risk attitude with their investments, but when it comes to the strategies we are about to discuss, they take on more of a scarcity mindset.
It is well known that entrepreneurs and real estate investors create the most wealth in the world. I am going to explain how you too can benefit from the same strategies the wealthy use to create wealth.
But first, we need to identify what makes these two categories of people better positioned for wealth creation than others. I believe there are three things that set them apart:
Most often when a real estate investor purchases a property or constructs a building, they acquire a loan from a bank to fund the project. Seldom do they pay for properties in cash. The more resources they tie up in one property, the less cash they have available to acquire other properties. By using the bank’s money to leverage their purchases, they can use the same amount of money to acquire multiple properties. You’ll see why this is important in a moment.
The investor collateralizes the property in exchange for the capital to acquire the property. Say an investor buys a property valued at $100,000. The bank funds 75% of the purchase price and the investor funds 25%. By doing this, the investor now has a property valued at $100,000 that they paid $25,000 out of pocket to acquire.
From a retail perspective, you may point out the fact that there is a loan and the equity position is only 25%. That is true, but there is more to understanding why this is a huge advantage for the investor. Which leads me to the next point.
What many people fail to understand about real estate is that the property is worth the same whether or not it has a mortgage. In our example, even though the investor has a loan of $75,000, the property is still worth $100,000.
This is important as the investor – not the bank – benefits when the property appreciates. The investor gets the benefit of a $100,000 property appreciating with only $25,000 invested. In other words, if the property appreciates by 5%, or $5,000 on the $100,000 property, this is effectively a 20% yield for the investor’s $25,000 investment. This is what is known as an internal return.
Of course, no investment property is acquired without the potential for creating cash flow from the operations. Whether it is a business operating within the property or a rental agreement, the investor has a plan for creating cash flow from the property’s use.
Now, this is where the multiplication occurs, and the idea of internal and external returns is revealed … explaining how this strategy grows wealth.
Continuing with the example of the $100,000 property, let’s assume the property is rented out. Let’s assume the rent collected is $1,200 per month, or $14,400 per year. Using the same math as before, $14,400 would equate to 14% of the value of the property and a whopping 57% on the investor’s $25,000 investment. This is an external return.
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