A mistake humans often make is that we think about the future linearly. This applies to all facets of life. Whether we think of personal learning, technological innovation, or investing, most people project out growth linearly. What people often don’t realize, and this is something I’m guilty of as well, is that growth often compounds.
Tim Urban sums it up best in his blog, Wait but Why: “It’s most intuitive for us to think linearly, when we should be thinking exponentially.”
In order to think about the future correctly, you need to imagine things moving at a much faster rate than they’re moving now. This mentality applies to real estate investing as well. The beauty of investing in real estate, is that returns compound over time.
Cash flow, property appreciation, and leverage are three strategies investors use to make money in real estate. In this article we’ll explore how compounding in real estate works and explain how even a small investment can steadily grow larger overtime.
What is Compounding?
Compounding occurs when an investor makes additional profits from not only the initial investment made, but also on the profits that they’ve accumulated so far. Instead of periodic profits from an investment sitting idle in an account somewhere, they are combined to help multiply returns.
Let’s explore how compounding magnifies returns. Assume an investor has $10,000 in an asset that pays an annual interest rate of 8%. Over a 5-year holding period, the investment would generate over 17% more in additional returns thanks to compounding.
If interest were only paid on the initial investment of $10,000, the return over the 5-year period would be just $4,000 ($800/year x 5 years). However, because of compounding, the investor generated a total return of $4,692, or nearly 17.3% more profit.
Let’s explore how compounding works for the “buy and hold” real estate investor.
How Compounding Works in Real Estate
One of the most common strategies in real estate investing is “buy and hold.” It’s typically used by real estate investors seeking to generate recurring rental income and build generational wealth over a long time horizon. In this approach, an investor will typically purchase a rental property, hold it for 5 years or more, and refinance or sell when the time is right.
Let’s explore an example of how a buy-and-hold investor might compound real estate returns over the long term by using the cash flows and equity from one property to buy additional properties over time.
We’ll make the assumption that the investor pays all cash for the 1st property and purchases an additional rental property every 5 years. The 25% down payment of future properties is raised from a combination of cash out refinances and out of pocket personal savings. In addition, we’ll make the assumption that property prices increase an average of 5% per year, and that net cash flow is the money remaining after all operating expenses and mortgage payment has been paid. Lastly, we’ll assume that rent prices and operating expenses remain unchanged for the 20 year holding period.
The above example made certain assumptions such as home price increasing at a fixed rate year-over-year or rental income and expenses staying the same. In reality, that’s almost never the case. If you want to model out purchasing a rental property yourself, feel free to use the pre-built spreadsheet we created (just make a copy and input your variables into the highlighted cells).
The key takeaway from this example is that you can use the cash flow from your initial properties to reinvest into additional properties and slowly increase the number of homes in your portfolio. With each investment, you earn more money, enabling you to exponentially increase your assets and passive income.
When most people think about getting rich, they envision making a large sum of money through a single transaction, such as investing in crypto and hoping for a 10x. However, the reality is that building wealth is more often a slow and steady process. As your investment portfolio grows, the interest you earn each year snowballs, leading to exponential growth.
Compounding with Properties on Homebase
The previous example makes the assumption that you already have $100k to get started with. In reality, the majority of home prices are far greater than that; in fact, the median home price in the US is ~$400k. This makes real estate investing an asset class that is too expensive for many people to benefit from.
At Homebase, we fundamentally believe that everyone should have access to real estate investing. To that end, we’re fractionalizing rental properties to make minimum investments as low as $1000.
The principles around compounding work in the same way for fractionalized real estate. Invest in a property on the Homebase platform, earn passive income via rent every month and slowly build wealth over time as the home appreciates in value. Because all properties on the Homebase platform are acquired with no debt, you’ll have the option to collateralize your fractional shares in the home and take on debt yourself to amplify your returns. That way, you are still able to utilize the cash flow from the property and debt from collateralizing your shares to reinvest into additional fractional shares in the same home or in different homes on the platform.
Our goal is to democratize access to real estate investing and give everyone the opportunity to compound wealth — one home at a time.
Domingo, Homebase Co-founder