Most people dream about financial freedom or at least having sufficient wealth not to have to worry about their day to day needs or their family’s future. The thought of doing something about it, however, is often very daunting. For most of us the idea of amassing $1 million in superannuation before retirement or saving a deposit for our first house (even outside of Sydney) seems likes a huge task. But it doesn’t need to be – read on to see how principles taught in year 8 maths could change your financial future!
We hear a lot about housing affordability, with house prices in Australia some of the most expensive in the world, and how difficult it is for first home buyers to get a foothold in the market. When I bought my first property in 2006, prices were considerably lower than they are now but it still took me a very long time and a lot of sacrifices to save a deposit. The task has only become more difficult due to higher prices and stricter lending criteria. The idea of saving a $100,000 deposit to buy a $500,000 apartment is daunting enough, let alone building a $2 million or $5 million portfolio.
This is where year 8 maths and the secret of compounding, or what I like to call the snowball effect, comes in. Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings, snowballing over time. Compounding is such a powerful force in finance and in our lives in general that Albert Einstein call it the 8th wonder of the world.
The power of compounding can be demonstrated by looking at a sheet of paper – if we took a sheet of paper, one thousandth of a centimeter thick (0.001 centimeters), how many times do you think you would need to fold it in half before the stack of paper was higher than the Eureka Tower in Melbourne? Go on, have a guess! Would it surprise you if I told you that after 25 folds you would have a stack taller than the Eureka tower, even taller than the Q1 tower on the Gold Coast – which is Australia’s tallest building?! Don’t believe me? Whatch this fascinating Ted-Ed video How folding paper can get you to the moon.
Exactly the same principles can be applied to property investing. When you start out investing, it is very difficult to build a portfolio. Your first purchase is a mammoth achievement and at the time a second seems near impossible. In time, however, you build some equity in your first property and you are able to leverage that equity to purchase your second – now just stop for a moment to think about what you’ve just done – you’ve folded your paper, you’ve only increased your portfolio from one property to two but that is a 100% increase in the size of your portfolio! If you fold you paper again, you will increase your portfolio from two properties to four. Folding two more times, you will double your portfolio to eight and then from eight to 16 properties. Now to most people a portfolio of 16 properties seems like the stuff that dreams are made of!! But if you understand that owning 16 properties only requires to you to double your portfolio four times (and that doubling from four to eight or from eight to sixteen takes exactly the same amount of energy that it takes to double from one to two) it seems so much more achievable. This is a lightbulb moment for many investors who want to grow a portfolio but who have felt overwhelmed with the size of the task.
Now the amazing part about building a portfolio is the increasing wealth generation potential as the size of the portfolio grows. If we assume, for the purpose of this calculation, that property grows at 5% per year, if you own a portfolio of two properties each valued at $500,000, your portfolio will grow by $50,000 in the first year. If you double your portfolio twice, first to four and then to eight properties, again each worth $500,000, your portfolio will be worth $4 million and will grow at $200,000 per year. Double again and all of a sudden you portfolio is growing at $400,000 per year! Unbelievable!
You’re probably thinking, well I understand the maths but doubling my portfolio – is that really achievable? Well, the answer is yes. Now, markets never perform the same over time and you will find that there are often markets within markets, so growth can never be guaranteed and you should always seek advice from an independent, unbiased adviser (such as a Qualified Property Investment Advisor – who has met Property Investment Professional Australia’s (PIPA) education requirements and subscribes to PIPAs code of conduct), however, well located, quality, residential property has historically grown at something like 7% per annum. Using our previous example, if you hold a $1 million portfolio for three years and it grows at 7% per annum, at the end of year three it will be worth approximately $1,225,000. In theory, the additional equity of $225,000 could be drawn down and used to purchase additional properties. If you were to use $150,000 of your $225,000 for deposits on new properties (retaining the other $75,000 for closing costs and a repayment buffer) and borrow against the new properties at an 80% loan to valuation ratio, you could purchase new properties to a value of $750,000, giving you a total portfolio value of $1,975,000, almost double your original portfolio value. This process can, assuming consistent growth in your portfolio, be repeated again and again.
Now, as we discussed earlier, growth in your portfolio is never consistent, some properties will underperform and others will overperform and they may do so as at different times as different markets respond to different growth drivers – so you must build your portfolio slowly and as your overall circumstances allow. It is important also to note that the example requires high overall leverage and should only be considered by experienced investors after obtaining appropriate property investment advice – but it demonstrates that it is possible to double your portfolio in a fairly short space of time, without the need for large amounts of additional capital.
The power of compounding allows many investors to understand that in acquiring their first investment property or building a portfolio of two or three properties, they have already done much of the work required to build a significant portfolio that is likely to deliver them the financial freedom they desire.
Are you building a portfolio? Do you have an investment plan? Are you currently harnessing the power of compounding?
Why not get in contact with Real Estate Wealth for a free and completely independent strategy session and find out how to take your first steps or how to take your portfolio to the next level! Contact us at firstname.lastname@example.org.