The miracle of compounding is what it’s called. The ability to earn interest on interest is the simplest way to put it. Start out with a hundred bucks at 8% annually and beginning the second year you’re earning 8% on $108. Keep that up for about nine years and you have $200. So if at age 30 until age 65 you put away $4,000 yearly, compounding annually at 8%, you’d end up with just under $690,000. And if it was in an IRA or 401k that money is taxable as it comes out. Of course, if for some reason you don’t need it, and wish to have it continue compounding, tough luck. Uncle Sam will force you to begin taking it out and paying taxes on it. But I digress.
What does return on investment mean? Try getting three investors together to decide the answer to that one. Is it cash flow? Do tax benefits come into the picture? Is it simply a function of money in and money out? Cash on cash? All the above? None of the above? I’ve heard all kinds of definitions.
Does it really matter?
If you invest $100k today and upon selling receive your original capital back plus another $100k in four years, do you care what your ROI is? No, you’re too busy bragging to your brother-in-law, who wouldn’t go in with you at the beginning, how you doubled your money in 48 months. Your ROI is the pained look on your sister’s face, right? 🙂 All you care about is you put $100k in, got $200k out, and you’re ready to rock ‘n roll again.
But what does it take to accomplish that? In rough numbers, if you bought $455k in income properties at 20% down, with about 2% closing costs, you’d have needed $100k to close the escrow. If for four years those properties increased in value at 7.6% each year they’d be worth in the neighborhood of $610k. (And yes, there are places where properties are going up at that rate.) If your total cost of selling was 8%, you’d have roughly doubled your money in 48 months. Because you’re sane, you would take advantage of Section 1031 of the Internal Revenue Code and defer any capital gains taxes, through the famous tax deferred exchange. Of course you would only do that if you liked doubling your money twice as quickly as your brother-in-law, which you do — immensely.
Over 36 years imagine what your final tally is when you’ve been doubling your original money ($100k) in roughly half the time it took your IRA/401k. What if, instead of taking four years, it averaged six years to double your money? In 36 years you’d have way over $6Mil. If you knew where to invest, and adjusted geographically when necessary, you would have done this in the 36 years just ended. Debate just came to an abrubt halt.
This isn’t a game. These numbers are real. The 36 years just ended really happened. In those years we experienced many recessions, an S & L crisis, one period of massive inflation, three wars, and a major terrorist attack on our soil. And yet you would have still earned your $6Mil+ by paying attention to the market, and knowing which regions were ripe at what times.
For some investments I execute an after tax cash flow analysis. From these numbers I then compute what’s known as an Internal Rate of Return, or IRR. I’m not even going to link to a definition of that term because though it’s cool to know, most investors don’t give a rat’s rear-end what their IRR is. What they do know is they put in X-dollars and took out 2X-dollars. They care about how long it took. They don’t think much about ROI. What they care about strongly is growing their capital.
A last word about compounding. It’s a rewarding concept to say the least. Einstein rightly called it the Eighth Wonder of the World. The real miracle is having your capital compound at a rate 5-10 times that of non-real estate investments. Simply put – invest $1 but benefit from compounding $5-10. That’s a miracle – or a new use of the theory of relativity. 🙂 Over your working lifetime it can mean the difference between ending up with hundreds of thousands vs several million dollars. This is why the majority of folks with two commas in their net worth did it mostly through real estate.
How much you make on your investment, and how long it takes are what matters. Put another way — More is better than less — sooner is better than later; and more sooner is much mo-better.
NVmike says:
The miracle of compounding is what it’s called.
Since the 401(k) is also compounded, the real estate example you provided derives its advantage over the 401(k) via leverage, not compounding.
January 16, 2007 — 8:18 pm
Jeff Brown says:
>A last word about compounding. It’s a rewarding concept to say the least. Einstein rightly called it the Eighth Wonder of the World. The real miracle is having your capital compound at a rate 5-10 times that of non-real estate investments. Simply put – invest $1 but benefit from compounding $5-10.
I thought that’s exactly what the above text said.
Put differently, real estate allows compounding to be turbo charged via leverage AND compounding on an amount much larger than actually invested. Hence – the advantage.
Thanks for your comment.
January 16, 2007 — 11:12 pm