There are two wealth accelerating tools that I employ in my real estate investing. The first is leverage or the use of fixed bank financing to purchase a property which I will write about in my next post. The second wealth accelerating tool is velocity of money. In its simplest terms, velocity of money is how quickly a dollar invested returns to its owner to be reinvested.
With stock and mutual fund investing, the most popular strategy is the buy and hold strategy. I too like to buy and hold for the long-term. However, I prefer to buy and hold real estate over paper assets. Over time, the principal gets paid down by the renters and the value of the property rises through net operating income (NOI) increases. As such, a large amount of equity can build up. Allowing that equity to sit there idly and not work for you is the definition of a lazy asset.
How can I access this growing equity? The most obvious answer is to sell the property. This is what you do with stocks and mutual funds. If you want to access your money, you have to sell and pay a tax on the gain. However, I don’t want to cannibalize my quality performing property, I just want to access the equity so I can go out and buy a second quality performing property. To do this, I use a refinance to harvest the equity tax-free.
Equity harvesting is a powerful wealth building tool that illustrates the concept of velocity of money as it pertains to real estate. It is important to remember that if you are going to harvest equity, use it to buy assets and not liabilities. It is easy to misuse this concept and buy yourself a boat, a sports car, or a myriad of other liabilities that will make you poorer and not richer.
On the other hand, if you harvest your equity through a refinance, combine it with the incremental cash-flow that you have been receiving, and buy another performing asset your one property becomes two. Continue to drive NOI and pay down the mortgage and in another four to five years, you can refinance your two properties and buy another two. Now your initial one property has turned into four cash flowing properties.
This has a wealth accelerating effect that will expand your nest egg rather than just allowing your equity to grow and sit lazily doing nothing. I recently compared the returns of a stock held for 10 years compounding at 10% annually with an apartment building held for 10 years employing periodic refinances to buy more properties without any new infusion of capital. Obviously 10% is generous for stock as the real historic return for the S&P 500 is more like 6.5%. Additionally, I would not be interested in a property that only returns 10% a year. Utilizing leverage, I routinely target properties that give an overall return in the 15% – 20% annual overall return range. However, to approximate an apples-to-apples comparison I assumed a 10% annual return for each. At the end of 10 years utilizing the concept of velocity of money, my real estate investment returned me almost three times as much as my stock investment.
Many of us have been practicing for ten years now and longer. How much closer to financial freedom and early retirement would you be if your current nest egg was worth three times as much as it is now? The concept of velocity of money and its wealth accelerating effects are powerful. The uncertainty of today’s medical climate with its decreasing reimbursement and increasing regulations makes it even more important that every health care professional learn as much as they can about accelerating their wealth as safely as possible.
P.S. Velocity of money through equity harvesting has a wealth accelerating effect like no other that allows you to grow your nest egg and make money in real estate.
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Dear Dennis,
I found your site through your white coat investor guest post. I can absolutely understand how refinancing would allow you to take advantage for further investment, however, if you are only a fractional investor how would you go about doing this? If you have 5-10 other partners and some of them don’t want to refinance I could imagine that things could get pretty hairy pretty fast. Keep up the good writing!
Hello Jesse,
Thanks for the comment. If you are putting the deal together, then you need to explain your business plan to your fractional investors before they invest. You could run into the same type of problem if your business plan is to buy and hold and you get a bunch of investors who want to fix and flip for a quick profit. Once they know your business plan, then they can make an informed decision on whether or not to invest.
My business plan is to buy 80 – 250 unit properties in the best markets in the country. Hold for the long-term enjoying cash-flow and periodically refinancing for equity harvesting to buy more quality cash-flowing properties. Having said that, when you refinance the property you will give the investor their fractional share of the refinance. Ultimately, they will decide whether to reinvest with you or do something else with their money.
The best way to show someone the advantages of refinances is to go over the math with them. I debated doing that in this post, but ultimately thought it might be too confusing. If you proforma out the financial benefit of buying and holding a property for 10 or 20 years versus refinancing every 5 years and adding new properties, the difference is material. It truly does have a wealth accelerating effect.
Hi Dennis,
Great website. I have purchased a single tenant commercial property with another partner and have had it for almost five years. The problem we ran into on recent refinance is that the appraisal was ridiculously low, and thus not allowing for a lot cash out. When I questioned the banker and appraiser, it appears they are really protecting themselves to my detriment. Have you run across this recently and any thoughts on this?
thanks,
VK
Hello Vasu,
Thanks for the comment. Unfortunately commercial office is still very suppressed nationally and office CMBS lending is anemic. Consequently, local/regional banks can be the only game in town. They look at variables like tenant quality, remaining lease duration, total DSCR of the deal for the lender, total debt yield for the lender, safety level of the overall market, etc. Unfortunately, this caution may make it harder for you to harvest as much equity as you could have otherwise.
The multifamily space has been better. As the economic crisis hit and drug on, multifamily kept getting better. A material shift out of home ownership and into renting occurred. Many baby-boomers are down sizing into apartments and the echoboomers are coming into their prime rental years. While there has been some tightening of the underwriting, valuations have been good. A lot of this has to do with the quality of the markets we are in and the quality of the asset class.
Hello Dennis
I am first time buyer trying to get maximum leverage. What are your thoughts on that? just to get out of medicine quickly.
Hello Jess,
I hear warning bells when I see “first time buyer” and “maximum leverage” in the same sentence. Leverage is a tool, that can provide for enhanced returns. However, it does have a downside. The risk gets magnified if you take a full-recourse loan which is standard with residential and smaller commercial properties. Make sure you become well informed or you invest with someone who is well informed before taking the plunge. May I suggest you start by signing up to the website for blog post updates and listen to my free download.
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