The three dimensions through which Investors build wealth

[Jorge Vazquez]

Three dimensions = Appreciation, Cash flow, and Leverage.

I’m a Marvel fan. Even though I loved reading DC comics as a child, I enjoyed the Avengers franchise far more than any of the DC films (the Dark Knight trilogy by Christopher Nolan was an exception). In each of the Avengers movies, the team does its best to secure one of the Infinity stones. Each stone has a unique power and when wielded well has the power to transform everything around it. No one stone is better than the other. They are all equally powerful in their own way.

Today, I’m going to draw a parallel between real estate investing and three infinity stones. In the world of investing, there are three primary dimensions of wealth building. All dimensions are significant and powerful.

Time stone = Appreciation

In the Avengers series, the Ancient One has been guarding the earth for centuries. She has the ability to wait. She is a paragon of patience and acts swiftly at the right time. She is the keeper of the ‘time’ stone.

The Ancient one bears the qualities of an investor who is focused on appreciation. Appreciation is largely a function of time. Properties where I live in Tampa bay have appreciated by 7 - 10% every year for the last 10 years. The appreciation forecast for 2021 is between 7 - 12% in most zip codes. Needless to say, that is a substantial return and if you can ride the appreciation wave, it can create extraordinary returns. This is usually one of the biggest benefits of real estate investing over time. The appreciation can be realized when the property is sold and if you follow certain guidelines, you can defer any taxes on the appreciation of the property and roll it into your next investment.

A house flipper is also playing along this dimension of appreciation. The value that comes from rehabbing a property is referred to as ‘forced appreciation’. A flipper tries to purchase a property well below market value and seeks to sell the property at market value based on the improvements made. The price difference is the forced appreciation of the property.

Appreciation is like your best friend who bails you out of trouble. I have met several investors who overpaid when they bought their properties and realized their mistake later. They had the patience to sit on the properties and allow them to appreciate. As time passed, the added equity in the properties made the investments worthwhile. If you have made the mistake of overpaying for a property, appreciation can help you overcome your mistake too. As my mentor used to say, ‘All good things come to those who can wait’.

Soul stone = Cash flow

The heart and soul of real estate investing is Cash flow. This is the central reason why investors purchase rental properties. Just like the Red Skull gives guidance and advice to those who seek the soul stone, every investor who seeks cash flow educates himself in the art and science of calculating cash flow. I have seen several investors who have grossly underestimated expenses and thereby overpaid for rental properties. A good rule of thumb is to look for properties that meet the 1% rule. If the monthly rent is 1% of the purchase price, the asset is likely to cash flow well.

Cash flow is of central significance in multifamily properties because the appraisal value is based on the income it produces. All commercial real estate is sold as a function of income and it boils down to how much cash flow the property produces each month. Properties are commonly sold at multiples of the cash flow they bring in.

Investors who look for cash flow are usually long term investors who are seeking to create a reliable source of passive income so that they can achieve financial independence and retire early.

In certain instances, cash flow and appreciation share an inverse relationship. Usually in bad neighborhoods, appreciation is low but cash flow is high. In desirable neighborhoods, appreciation is high but cash flow is low. The secret lies in finding a suitable neighborhood that gives you the best of both worlds: Safe middle income neighborhoods tend to provide high cash flow along with steady appreciation.

Power stone = Leverage

The power stone in the Avengers is incredibly potent. He who can wield it can do wonders with it. Star Lord and the Guardians use it to overwhelm Ronan who was the most formidable foe they had ever encountered. Such is the strength of the power stone.

In the same way, Leverage in real estate is incredibly powerful. It can allow you to supercharge your return and overcome several obstacles in one sweep. Leverage is like a sword, it can cut through your problems but if you are not careful, it can hurt you too. Leverage is an amplifier, it amplifies the positives and the negatives.

Leverage is utilized by investors by borrowing money to either purchase or refinance a property. The lender typically gets only the interest. The investor gains all the equity that is gained through appreciation. For example, if an investor purchases a property for $100k with an $80k loan, he would need to put only $20k down. If the property appreciates by 10% at the end of the year, the investor would have gained 50% in terms of the amount invested. Investors who focus on leverage tend to rely on the following metric: ‘Cash on cash return'. The highest cash on cash return is gained by having no money invested in the property. This creates an infinite cash on cash return (anything divided by zero is infinite). This is achieved either by purchasing the property with nothing down (some kind of creative financing) or using the BRRR technique (Buy-Rehab-Rent-Refinance) where the forced appreciation adds enough equity to cover the entire loan to value ratio at the time of the refinance. This allows the investor to recover the entire initial investment.

Mapping deal types to dimensions

In practice, investors combine advantages from all the three dimensions described above. However, for each deal type, the predominantly relies on one of the three dimensions.

Flippers look for forced ‘Appreciation’

Landlords look for ‘Cash flow’

BRRR Landlords look for ‘Leverage'

Secondary dimensions

Two bonus dimensions that come with real estate investing are ‘Loan Paydown’ and ‘Tax Advantages’. Even though these can add significant value, very few investors make these their central focus. The deal must provide at least one of the three primary dimensions mentioned above. The secondary dimensions add the icing on the cake.

Conclusion

In Avengers Endgame, Iron Man uses the combined power of all the infinity stones through the ‘Snap’. It has profound impacts on everybody’s reality and future. Real estate investing can be incredibly powerful. If you can combine the different dimensions described above, you can achieve F.I.R.E (Financial Independence, Retire Early) much sooner. It has the power to transform your financial future.

What’s a good fit for you?