HOW INVESTING IN PROPERTY WORKS
Disclaimer: The information in this article is general only, in the examples below, I have left out other cost and taxes for the sake of simplicity, before making any financial decision you should seek the advice of a qualified professional.
Hey guys, hope you are well
In this article I am going to explain to you how investing in property works, based on my many years of studying the subject and having parents that own investment properties.
So what is an investment property and how do they work?
An investment property is a property you own that you rent out to someone.
You buy a property, this could be a house, apartment, office or some other type of property and you provide the value/service of shelter to another human being in exchange for currency.
Rent is not the only way income is generated, the value of the property increases over time.
Many people will tell you properties will grow 10% a year every year or they will go down in value and stay down forever but this is bullshit.
Property prices go up some years and down some years, but over the long term, you will see that they average out to the rate of inflation.
This is actually quite simple to understand but it’s amazing how many people don’t understand this concept.
The median property price is determined by the buying power of the average people and their incomes.
Its supply and demand, if the average income is $60k a year, it can only buy a certain $ amount of property.
If incomes go up over time with inflation (cost of everything going up) then naturally houses will go up by the same.
The other way investment properties make money is from rent, generally a 5% yield is considered good. What does this mean? For example if you have a 400k property you should typically rent it out for 20k a year or around $400 a week.
So what makes investing in property a good idea? Well let’s compare have 400k in the bank to a 400k investment property.
If you have 400k in the bank, the bank will pay you an interest rate which is typically the inflation rate, so you are not actually making money as a lot of people think, you are merely maintaining the current day value of that 400k.
So in our example the bank pays 3% interest on your money to you. The inflation rate is also 3%.
In 30 years’ time your 400k will change to 970k but the value of that will still be 400k.
Now if you had 400k in an investment property, since that also kept up with inflation, not only would it maintain its 400k value in 30 years’ time from the 3% inflation, but you would have been receiving an extra 5% in rental yield.
So you can see that if you just leave your money in the bank, you break even, but by having your money in a property, you make money from the rent.
Cash in bank 3% (interest rate that mirrors inflation)
Investment property 8% (inflation + rent)
So you can see if you own an investment property outright, there is no point getting to excited over the growth in value as this is just maintaining the value, you are not actually making money, you make you money from the rents, if of course you own it out right, but what if you don’t own the property outright, now I will explain the second way people can make money from investment properties.
Most people cannot afford to buy a property outright but here’s the other way to make money.
Let’s assume you buy a 400k property, you put in 20% as a deposit (80k) and borrow the remaining 320k from the bank and then rent the property out at a 5% yield which is 20k a year.
This is what it would look like after one year.
Property 400k + 3%inflation = 412k
Interest on 320k loan (5% interest rate) 16k
So you put in 80k of your own money and received 12k back.
I know what you’re thinking.. WOW that’s a 60% return!!! I can only get 3% in the bank and 8% on the stock market at this rate I will be RICH!!!!!
But although it is 60%, you have to understand and a lot of people don’t seem to see the big picture, but that capital growth in your property value isn’t compounding on your 80k deposit.
Back to our first example, this is how it would look after 30 years assuming you don’t pay off the loan at all by letting the rent pay off the interest.
Property value 970k (400k present value)
Total capital growth 570k
Loan amount still 320k
Total money put into property 80k deposit
Percentage needed to turn 80k into 570k over 30 years = 7.2%
So really over time you are not getting 60% you are getting 7.20%, now your return would be higher if you had say a 5% deposit as opposed to 20% but in Australia if you put in less than a 20% deposit you will need to pay the lenders insurance which will eat away at your returns.
So you can see that whether your goal is to buy a property and pay it off in full or just put in your deposit and let the value grow, you are really getting a similar return, it seems to be around the 8% in my example.
“but I will keep buying property after property and become rich!!”
In either of our examples, the return from investing in properties isn’t super high, yes it beats having money in the bank, that’s why people do it but as a plan to get rich, I don’t think it’s the best way.
The average person is an employee, let’s say the average salary is 60k a year, there’s only so many properties you can buy and equity you can build, you will have a lot of debt, in the future you will need to pay that debt off by selling a property or two, yes its better than not doing anything, but you will end up well off, not rich (by rich I mean in the 10s of millions) and it will take many years to get there.
“I will buy run down properties and fix them up and sell it and use the money to buy a bigger property and keep doing that”
Yes you can make money this way, but be prepared to spend your weekends renovating your properties, missing out on loss rent, paying tax’s on capital gains every time you sell, problems with contractors etc etc.
So what do I prefer?
Personally I would use the money to start a business where I could potentially get returns in the 100s and 1000s of percent each year (I will write an article on getting rich through a business soon)
A business would give me leverage not limited by inflation or rental yields.
I see property as more of a wealth holding vehicle which can still get you a nice stable return which will generally beat having your money in the bank, but if you really want to get rich, not just well off by the time you are old, property might not be the best/fastest way to get there based on mathematical limits relative to the average person who works a job trying to get rich from scratch.
That’s it for now people, this is my understanding of how investing in property works, I hope I have introduced or clarified the subject to you, this article is not meant to be a what to do article, it is more of an explanation, if my views change over time I will be sure to update this article, and you should definitely form your own opinion and seek the advice of a trained professional before making any financial decision.
Please be sure to ask any questions or post comments below and I will be sure to reply to you.
Good luck with your financial journey!