Principal Paydown And Appreciation: How Do I Invest To Grow My Net Worth With Real Estate?
So, you’ve got some cash to invest but are trying to figure where and how to invest it. If you have followed the right steps to get started in real estate investing then you have begun to consider the different type of investment strategies you could use. One of the questions that you have probably kept coming across was whether you should invest for cash flow and on-going income or to grow your net worth via appreciation.
If you are new to this whole investing thing cash flow and income may be familiar to you as it is similar to how you currently get paid regularly by your W2 job. This concept of net worth on the other hand may seem a bit more foreign. It should not be understated how important net worth is for building generational wealth for you and your family.
What is net worth?
Yes, that job that provides you high income is great, but is it enough? While a high income is great, net worth focuses on the overall picture of your financial health.
Net worth, put simply, is the difference between the value of things you own and things you owe. Put technically it is the difference between assets (possessions that have value) and liabilities (debts that you owe to creditors). This difference may also be referred to as equity. Depending on what context you are in there may be certain exclusions from what assets and liabilities you would include in that formula.
Even if you lose that high income job (and it’s very possible you may), your net worth may be very valuable to you as a resource in continuing to build wealth and get cash flow despite your employment prospects. A high net worth allows you access to better financial opportunities such as loans or select investment opportunities that would in change continue to grow your income and net worth.
If you are not sure about what your net worth is, you should be sure to take time and find out what your status is.
How to increase your net worth in your 20s, 30s, 40s, 50s and beyond!
There are many ways that you can increase your net worth. The most basic way to increase your net worth is to increase your income and assets and decrease your expenses and liabilities. Below are some suggestions on how you can use both of those strategies to increase your net worth.
Asset and income increasing activities:
Get a higher paying job
Get an additional job or side hustle
Save more of the money you make
Invest in assets that produce additional income (stocks, real estate, businesses etc.)
Expense and liability reducing activities:
Reduce spending
Pay off debt or change the terms to lower liability
As we are a real estate investing group, we will focus on how you can see outsized results via real estate investing that allow you to double, triple and more your net worth in a very short time frame.
Let’s talk about equity – how to double your net worth in one day
Equity is a very powerful tool. You may have heard about such things as homeowner’s equity loans where homeowners can leverage the value of their homes to get money. Your net worth (effectively your personal equity value) can do the same for you.
Equity comes in two different flavors when investing in real estate; principal pay down and appreciation. These 2 flavors become available to you once you purchase a real estate asset. There is a third type of equity however that we will call “built-in” equity.
See, one of the great things about real estate investing is that real estate it is a fractured market. That means that you can purchase real estate investments at a price under its current value. Sometimes sellers are in distress because of financial or family issues and will sell a property below value to get cash quickly. This means that you are able to purchase an asset for less than what it’s worth which allows you to take a portion or all of the equity that that the previous owner built. This built-in equity is the difference between the value of the asset (usually verified by an appraisal) and the price you paid for it.
Because you are using leverage and purchasing the investment with a loan of less than 100% there will be some additional equity that you bring to the table. If you were so hardworking and lucky to find the right investment deal you could in theory double your net worth in one day. Let’s assume that you are a renter with no debts and have $100,000 saved in the bank. All you have to do is find a $200,000 property that is being sold at 50% of it’s market value (which may happen more frequently than you think due to various motivations of the seller.) Assuming you bought that property all cash on the day you closed on that property you would now have a $200,000 net worth (double what you had the day before.) Of course, there may be some closing costs or rehab you have to do subsequently but for simplicity sake you would be roughly twice as wealthy that day.
When you use leverage the potential for this effect is magnified. Imagine you purchase a $700,000 apartment complex for $500,000 (i.e. it is 30% under value and has $200,000 built in equity). You would still bring your same $100,000 of equity to purchase the building but now you are getting and additional $200,000 of built in equity making your total equity position $300,000. You just tripled your net worth in one day! How’s that for increasing your net worth quickly?
Investing for cashflow and income vs investing for equity and growth in your net worth
Your investment strategy is impacted by your goals and your current financial and personal situation. Depending on your age, employment status, current ongoing income/cash flow, family responsibilities, dependents that you have, lifestyle, risk tolerance etc. you may need cash now or you can afford to wait to have cash later.
One of the key differences between cash flow and equity is that cash flow is “money now” but equity is “money later.” Equity has the ability to be increased exponentially while cash flow increases are usually more stable and predictable.
Equity, in the terms of real estate investing, is unrealized value that you have in the investment property. This is the difference between the debt on the property and value of the property. That means you can not access that value until you perform some sort of capital action such as selling the asset or taking out a loan against the equity.
For someone who would rather get a smaller amount of money now that is recurring and predictable then it makes more sense for them to invest for cash flow. This person is most likely more focused on capital preservation than growing their capital.
If however you don’t need the money right now, as you have sufficient other sources of cash flow, then you may be able to invest with a more long term horizon where you will get a huge payout compared to the cash flow investor. Those that can invest for the long term without an emphasis on cash right now can invest for equity; said differently, they would invest to grow their net worth.
How is equity created in real estate investing?
Equity in real estate is created 3 ways as we mentioned before. There is built-in equity – equity that you can buy when you make smart purchases of an investment under its current value. Then there is equity that is created during your active ownership of the property. This equity created during your ownership are the two flavors of equity growth most frequently discussed; principal paydown and appreciation.
What is Principal Paydown in real estate?
Principal paydown is only an available means of equity growth if you purchase a property using leverage such as a bank loan. The outstanding portion of the loan is called the principal. Whenever you buy a property the bank usually provides 70%-90% percent of the money needed to buy the property and you provide the other 30%-10%.
In a sense you can consider this 30%-10% that you provide as the “first” principal paydown such that the bank is not providing 100% of the money and you have paid down the amount of starting principal you would owe to the bank after closing the purchase.
Once you own the property the bank will require that you pay them back at a set period (usually monthly) a combination of interest on the outstanding loan and a return of a portion of the principal. When this principal portion is paid down it reduces the amount of loan outstanding and, assuming the value of the property stays the same or increases, the difference between the loan and your property value also increase which creates more equity.
One of the benefits of using leverage is that these ongoing payments after purchase would come from the revenue generated by the property. This means your net worth is increased with each payment, but you are not the one making the payments.
Very often in commercial real estate investments loans start off as interest only so principal paydown may not kick in immediately. This is often done as investors will focus on activities that would subsequently increase both the cash flow and equity in the property.
What is appreciation in real estate?
Appreciation is the natural increase in value of a real estate asset above and beyond what the as is value of the property is at the time of purchase of the property. There are many ways that the property you own may appreciate in value. It is important to understand how real estate assets are valued to fully understand and appreciate the concept (and power) of appreciation. Said differently; you have to appreciate appreciation. Residential real estate is valued primarily on the value of surrounding properties. Commercial real estate properties are based on mathematical formulas that give an emphasis to the income generated by the property. With the understanding of this background in valuation you can comprehend the ways that real estate appreciates; inflation, market demand, speculation and active efforts.
Appreciation from inflation – Inflation is a naturally occurring increase in prices and fall in the value of money over time. You may have heard your parent tell you how a loaf of bread cost 25 cents when they were growing up; now it costs you a few dollars. That’s inflation. As the value of each dollar decreases over time the amount of dollars that you will need buy a similar property to the one you own will increase, effectively increasing the value of your property.
Appreciation from market demand – This type of appreciation is most apparent in residential properties which are valued based on sales of surrounding properties. Real estate value are a result of supply and demand. If the property is located in a high demand area because it has a lot of amenities, strategic location or other existing factor drives up the prices as people are willing to pay for access to these benefits. Further if there are more buyers than properties to buy this naturally creates bidding wars that drives up the prices.
Appreciation from speculation – Appreciation from speculation is similar to that of appreciation by market demand. The difference here is that there has not been a proven cause for the valuations and prices people are paying for properties. People are paying higher prices with the expectation of an increase in value. These buyers may have some insider knowledge or other data points to feel confident in their speculation however speculation by definition is not guaranteed.
Appreciation from active efforts – Forced appreciation is one of the best benefits of multifamily investing. Forced appreciation speaks to those that understand the methods of valuation of a commercial asset. Since a commercial asset is valued based on its income you just need to figure out a way to increase the income and you will increase the value.
A tale of caution about the hazards of investing for appreciation
As noted, those that invest based on speculation are hoping to gain but there is a possible down side risk that if the speculation and hope does not work they will lose their investment.
Appreciation is not guaranteed. Invest with caution. A more hedged strategy that provides the upside of appreciation investment, but the downside protection of cash flow investing would be most advantageous. Those that invest for appreciation may ultimately make more than an investor that solely invest for cash flow however they also take on more risk in exchange for getting that greater reward.
Principal Paydown and Appreciation in a typical multifamily syndication investment opportunity
A multifamily syndication may be designed to focus more on appreciation or more on cash flow. It is important to review the investment opportunity to understand what the investment strategy of the syndicate is to see if it aligns with your goals.
While all multifamily investment deals are unique, there are some generalities we can make of what to expect in a typical deal. First at the point of purchase of the investment there will be a pay down of the principal of the property with equity (cash from investors). Some loans may be interest only for the first 1-3 years and principal payments will only begin after that time. There should be a natural growth in rent and consequentially income of the property over the hold time thus increasing the value. Depending on how much value is added to the property then the deal sponsors may choose to refinance and return some capital to the investment partners.
Alternatively, the deal sponsors may choose not to refinance and wait until the sale of the property to return capital to the investors. On top of this return of capital investors will also receive a portion of the increased value of the property.
Best of both worlds and Infinite Returns
Paying down principal and appreciating the value of your property is an advantageous investment strategy as it protects your risk connected to the investment. This is especially true if the appreciation is occurring based on your active efforts.
There is one investment strategy that focuses on this combination specifically. This is called value-add investing. In value add investing the goal is to increase the value of the property significantly as opposed to operating business as usual. If the value is increased significantly enough, deal sponsors of value-add investments can return all of the investor’s original capital. The best part of this is that investors will still continue to get returns from the investment. If the investor has none of their original capital left in the deal, then this return is now infinite as they are getting paid with nothing at risk.
Principal paydown and appreciation are just a couple of the many benefits of investing in real estate. As you research and discover more you will start to understand why this asset class is loved by so many.
Interested in learning more about investing in multifamily apartments? Give us a call or check out some of the other free resources we have available at Investupmultifamily.com.