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Build Wealth With Real Estate  

 

 

 

 

 

So You'd Like To Build Wealth In Real Estate?

 

 

Take a look at a list of the World's Richest People as compiled by any number of organisations such as the US "Forbes 400 Richest Americans", or Australia's "BRW Rich 200 List", and look at where each of these individuals have built their wealth. Whilst these people have generated their wealth from a very eclectic field of businesses and professions, one stands out as more common and re-occurring than the rest: Real Estate!


And for those that haven't generated their wealth directly in real estate, many of them will use real estate as a secure and solid asset to funnel and further grow their fortunes.

So what makes real estate stand out above all the other asset classes as the vehicle of choice for wealth creation?

There are a number of reasons, but four principle ones:


1. Leverage

When purchasing real estate, it is not uncommon, particularly for a house and land package, to be able to borrow 80% or 90% of the purchase price. Depending on the location of the land, the lender, and your borrowing position (i.e. whether you already have other assets or secure "professional" employment), 100% lends are also possible.

If you went to your bank and told them that you wanted to buy their publicly listed shares and wanted a loan to do so, in most cases they would only lend you maybe up to 70% as a margin loan on listed shares in their very own bank! And yet this same bank would probably be more than happy to lend you 80% or 90% to purchase a well located property.

This is a testament to how highly regarded well chosen and well located real estate is as a secure and solid asset class.


2. A Real Asset - Everybody Needs a Roof Over Their Head

Unlike "paper assets" such as stocks or derivative market instruments, real estate is something real and tangible. It physically exists! Even more importantly than this is the fact that everybody needs a roof over their head, and we all need space and a place to live.

As long as there are people in a given area, there will be demand for real estate.


3. Limited Supply

Unlike virtually every other asset class, real estate is finite. Sure we can always build taller buildings with more apartments in them on the same size block of land, but there is only so much land, and only so much "well located" land near to public amenities, employment, and transportation. This is covered in more detail in the follow on article from this one on "investment property selection".

For now I am merely pointing out the second reason why real estate, particularly the land component of real estate, makes for such an outstanding asset class: because they aren't making any more of it!


4. Price Inflation

As discussed in point 1, your "leverage", or ability to borrow 80%, 90% or 100% of the purchase price of a piece of real estate, is only powerful IF your property appreciates in value. If it depreciates... you could find yourself owing more than you originally borrowed! Whilst that may be a scary prospect, it is also pretty easy to avoid. This comes down to the correct "Real Estate Selection" which is covered in the follow on article to this one (there is a link to it at the bottom of this page).

Real estate price inflation occurs for a variety of reasons:


a) Because of underlying inflation in the economy

Ever since the end of the Great Depression of the 1930's, western as well as most other economies around the world, have been subject to economic inflation. This is the progressive increase in prices for most consumer items, and the corresponding decrease in the value of the nation's currency unit.

During periods in the 1970's, 1980's and early "90's, many western economies were suffering double-digit inflation, and whilst this may at first sound great to real estate speculators, bear in mind that interest rates during those times were correspondingly often in double digits as well!

So far in the 21st century, most western economies have enjoyed very low interest rates and correspondingly low single digit inflation. This may or may not continue. Nobody has a crystal ball, and we could be in for higher interest rates and inflation in the future, or possibly a return to deflationary times which we have not seen since the 1930's. We need to be prepared for any and all possibilities. Fortunately, we are not dependant solely upon "economic inflation" for our real estate to appreciate. This is merely a contributory factor.


b) State of the Economy and Economic Health of the Nation

Real estate values also appreciate in line with the overall health of a nation's economy, and the wealth of its citizens. If a country is enjoying economic success, has a low unemployment rate, and its citizens enjoy an increasing standard of living, then real estate prices for "in demand" locations will appreciate. This type of market is not only dependent on owner-occupiers for price value appreciation, but will also be helped along by investors seeking to build their nest eggs with their surplus equity and funds. The level of real estate investment in an economy is directly linked to the investor's confidence in their nation's present economic outlook. As with other investment classes, fear and greed are significant driving forces for investors.


c) Increasing Population

As stated earlier, one very valuable aspect to real estate, specifically the land component of it, is that we aren't able to make any more of it! If a town, city, or even a particular suburb's population is on the rise, so too will the real estate values. It's all a part of the laws of supply and demand which influence the market values for almost every commodity.

This is one to take note of... If there are plans afoot for a new freeway, or a freeway extension, to link an outer suburb to the city centre, you might like to investigate purchasing some property in that outer suburb BEFORE the freeway is built. In many cases, the land values will increase several years before the completion of planned public works, so the earlier you can catch the wave the better. Such public works need not be limited to freeways or transportation infrastructure. A new shopping centre, or any other commercial project or public work that is likely to enhance the desirability of the area, can be a precursor to future capital gains for that area.


d) Limited Supply in an "in demand" area


As touched on in the preceding paragraph, increasing demand for a limited supply of real estate occurs for reasons other than population increase.

Whilst a particular suburb may have been manufacturing oriented, the factories may have closed down as that industry may no longer be viable. If the suburb is in a desirable location, maybe close to the beach or not far from the city centre, with good schools, shops and public transport, a process of gentrification may occur and the suburb may start to revitalise as a "café strip" lifestyle area. This will result in the area becoming more desirable to live in, and will attract more financially well-heeled property owners and tenants! The net result... property value appreciation.


So now that I have covered some of the reasons as to why real estate values appreciate, let's touch on why price inflation of real estate in particular can be such a powerful wealth creation vehicle.

It all comes down to that first magic ingredient that real estate provides us with so much of: leverage.

If you purchase a $300K house and land package at 90% loan to value ratio, you are effectively only investing $30K (plus closing & transfer costs) to purchase that asset.

It's historically quite common for real estate located in the metropolitan areas to double in value every 10 years. This is a compound rate of increase a little over 7% per annum.

For the sake of this example, I will assume a 5% per annum rate of appreciation. At the end of the first year, your $300K house and land package is now worth $315K. Hmm... not bad you say? Fantastic I say! You only invested $30K of your own funds, therefore you have effectively realised a 50% cash-on-cash gain within the first 12mths. You'd be lucky to make a 5% return if you had instead parked your money at your local bank in a Term Deposit. This is ten times better!

But this is just the beginning. Your property is now worth $315K, so let's roll over to year 2 with another 5% appreciation in value: your asset is now worth $330,750; year 3 $347,287; year 4 $364,651; year 5 $382,884; year 6 $402,028; year 7 $422,130; year 8 $443,236... but wait a minute you say... it's increasing in value by more than the original $15K per annum which we had after the first year? Indeed it is... because the value of your property is compounding! The increase in value, given the same 5% rate of appreciation, will become greater and greater as the years roll on.

Can you start to see the power in owning real estate? Now to be fair, property values generally do not progress at this rate in a linear fashion. Several years may go by with very little or no capital growth, and then suddenly we may experience several years of 10% or 15% per annum or more in capital gains. This is the cyclical nature of the property market at work, but again as stated, it is not unreasonable to expect that well chosen property will double in value in every ten year period.

Now the hardest part about building wealth in real estate is making your first purchase. This is the purchase where you will have to find that 10% or 20% deposit to fund it. But once you are "in the game" and own your own little piece of appreciating real estate, you can use the increase in value from your original purchase to make subsequent purchases without having to save up to fund the 10% or 20% deposit in cash for each future purchase. You can simply borrow against the increase in value of your original property to fund the deposit required to purchase your subsequent properties.

As time passes, you are creating a snowball effect, and your wealth will continue to multiply given stable economic conditions and well selected property in the right location.

So how do you determine what is a "well selected property" and what is the "right location"? Click the following link for part two of Building Wealth With Real Estate: Selecting the Right Investment Property.

 

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