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So You'd Like To Build Wealth In
Real Estate?
Take a look at a list of the World's Richest People as compiled by any number of
organisations such as the US "Forbes 400 Richest Americans", or Australia's "BRW
Rich 200 List", and look at where each of these individuals have built their
wealth. Whilst these people have generated their wealth from a very eclectic
field of businesses and professions, one stands out as more common and
re-occurring than the rest: Real Estate!
And for those that haven't generated their wealth directly in real estate, many
of them will use real estate as a secure and solid asset to funnel and further
grow their fortunes.
So what makes real estate stand out above all the other asset classes as the
vehicle of choice for wealth creation?
There are a number of reasons, but four principle ones:
1. Leverage
When purchasing real estate, it is not uncommon, particularly for a house and
land package, to be able to borrow 80% or 90% of the purchase price. Depending
on the location of the land, the lender, and your borrowing position (i.e.
whether you already have other assets or secure "professional" employment), 100%
lends are also possible.
If you went to your bank and told them that you wanted to buy their publicly
listed shares and wanted a loan to do so, in most cases they would only lend you
maybe up to 70% as a margin loan on listed shares in their very own bank! And
yet this same bank would probably be more than happy to lend you 80% or 90% to
purchase a well located property.
This is a testament to how highly regarded well chosen and well located real
estate is as a secure and solid asset class.
2. A Real Asset - Everybody Needs a Roof Over Their Head
Unlike "paper assets" such as stocks or derivative market instruments, real
estate is something real and tangible. It physically exists! Even more
importantly than this is the fact that everybody needs a roof over their head,
and we all need space and a place to live.
As long as there are people in a given area, there will be demand for real
estate.
3. Limited Supply
Unlike virtually every other asset class, real estate is finite. Sure we can
always build taller buildings with more apartments in them on the same size
block of land, but there is only so much land, and only so much "well located"
land near to public amenities, employment, and transportation. This is covered
in more detail in the follow on article from this one on "investment property
selection".
For now I am merely pointing out the second reason why real estate, particularly
the land component of real estate, makes for such an outstanding asset class:
because they aren't making any more of it!
4. Price Inflation
As discussed in point 1, your "leverage", or ability to borrow 80%, 90% or 100%
of the purchase price of a piece of real estate, is only powerful IF your
property appreciates in value. If it depreciates... you could find yourself owing
more than you originally borrowed! Whilst that may be a scary prospect, it is
also pretty easy to avoid. This comes down to the correct "Real Estate
Selection" which is covered in the follow on article to this one (there is a
link to it at the bottom of this page).
Real estate price inflation occurs for a variety of reasons:
a) Because of underlying inflation in the economy
Ever since the end of the Great Depression of the 1930's, western as well as
most other economies around the world, have been subject to economic inflation.
This is the progressive increase in prices for most consumer items, and the
corresponding decrease in the value of the nation's currency unit.
During periods in the 1970's, 1980's and early "90's, many western economies were suffering
double-digit inflation, and whilst this may at first sound great to real estate
speculators, bear in mind that interest rates during those times were
correspondingly often in double digits as well!
So far in the 21st century, most western economies have enjoyed very low
interest rates and correspondingly low single digit inflation. This may or may
not continue. Nobody has a crystal ball, and we could be in for higher interest
rates and inflation in the future, or possibly a return to deflationary times
which we have not seen since the 1930's. We need to be prepared for any and all
possibilities. Fortunately, we are not dependant solely upon "economic
inflation" for our real estate to appreciate. This is merely a contributory
factor.
b) State of the Economy and Economic Health of the Nation
Real estate values also appreciate in line with the overall health of a nation's
economy, and the wealth of its citizens. If a country is enjoying economic
success, has a low unemployment rate, and its citizens enjoy an increasing
standard of living, then real estate prices for "in demand" locations will
appreciate. This type of market is not only dependent on owner-occupiers for
price value appreciation, but will also be helped along by investors seeking to
build their nest eggs with their surplus equity and funds. The level of real
estate investment in an economy is directly linked to the investor's confidence
in their nation's present economic outlook. As with other investment classes,
fear and greed are significant driving forces for investors.
c) Increasing Population
As stated earlier, one very valuable aspect to real estate, specifically the
land component of it, is that we aren't able to make any more of it! If a town,
city, or even a particular suburb's population is on the rise, so too will the
real estate values. It's all a part of the laws of supply and demand which
influence the market values for almost every commodity.
This is one to take note of... If there are plans afoot for a new freeway, or a
freeway extension,
to link an outer suburb to the city centre, you might like to investigate purchasing
some property in that outer suburb BEFORE the freeway is built. In many cases,
the land values will increase several years before the completion of planned
public works, so the earlier you can catch the wave the better. Such public
works need not be limited to freeways or transportation infrastructure. A new
shopping centre, or any other commercial project or public work that is likely to enhance the
desirability of the area, can be a precursor to future capital gains for that
area.
d) Limited Supply in an "in demand" area
As touched on in the preceding paragraph, increasing demand for a limited supply
of real estate occurs for reasons other than population increase.
Whilst a particular suburb may have been manufacturing oriented, the factories
may have closed down as that industry may no longer be viable. If the suburb is
in a desirable location, maybe close to the beach or not far from the city
centre, with good schools, shops and public transport, a process of
gentrification may occur and the suburb may start to revitalise as a "café
strip" lifestyle area. This will result in the area becoming more desirable to
live in, and will attract more financially well-heeled property owners and
tenants! The net result... property value appreciation.
So now that I have covered some of the reasons as to why real estate values
appreciate, let's touch on why price inflation of real estate in particular can
be such a powerful wealth creation vehicle.
It all comes down to that first magic ingredient that real estate provides us
with so much of: leverage.
If you purchase a $300K house and land package at 90% loan to value ratio, you
are effectively only investing $30K (plus closing & transfer costs) to purchase
that asset.
It's historically quite common for real estate located in the metropolitan areas to double in value every 10 years. This is a compound rate
of increase a little over 7% per annum.
For the sake of this example, I will assume a 5% per annum rate of appreciation.
At the end of the first year, your $300K house and land package is now worth
$315K. Hmm... not bad you say? Fantastic I say! You only invested $30K of your
own funds, therefore you have effectively realised a 50% cash-on-cash gain
within the first 12mths. You'd be lucky to make a 5% return if you had instead
parked your money at your local bank in a Term Deposit. This is ten times
better!
But this is just the beginning. Your property is now worth $315K, so let's roll
over to year 2 with another 5% appreciation in value: your asset is now worth
$330,750; year 3 $347,287; year 4 $364,651; year 5 $382,884; year 6 $402,028;
year 7 $422,130; year 8 $443,236... but wait a minute you say... it's increasing in
value by more than the original $15K per annum which we had after the first
year? Indeed it is... because the value of your property is compounding! The
increase in value, given the same 5% rate of appreciation, will become greater
and greater as the years roll on.
Can you start to see the power in owning real estate? Now to be fair, property
values generally do not progress at this rate in a linear fashion. Several years
may go by with very little or no capital growth, and then suddenly we may
experience several years of 10% or 15% per annum or more in capital gains. This is
the cyclical nature of the property market at work, but again as stated, it is
not unreasonable to expect that well chosen property will double in value in
every ten year period.
Now the hardest part about building wealth in real estate is making your first
purchase. This is the purchase where you will have to find that 10% or 20%
deposit to fund it. But once you are "in the game" and own your own little piece
of appreciating real estate, you can use the increase in value from your
original purchase to make subsequent purchases without having to save up to fund
the 10% or 20% deposit in cash for each future purchase. You can simply borrow
against the increase in value of your original property to fund the deposit
required to purchase your subsequent properties.
As time passes, you are creating a snowball effect, and your wealth will
continue to multiply given stable economic conditions and well selected property
in the right location.
So how do you determine what is a "well selected property" and what is the
"right location"? Click the following link for part two of Building Wealth With
Real Estate: Selecting the Right Investment Property.
This
article is:
©
Copyright 2006-2008, Financially Free Pty Ltd. All rights reserved.
Copying or reproduction is prohibited
without prior permission.
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