I want to introduce you to an exiting financial rule that should get you all very excited. When investing (whether it be stocks, bonds or real estate) your investment doubles based on 2 variables. The first is time and the second is the interest rate. Allow me to explain - if you had $10,000 to invest in the stock market and wanted to know how long it will take to become $20,000, you would take the interest rate (say 6%) and divide it into the CONSTANT 72 to see that your money would double in approximately 12 years. Say you were more risky and tried to get 9% in the market, your money would double in 8 years (again, divide 9 by 72). You can see the obvious relationship between interest rate and speed to double.
Now apply that to our real estate rental properties. If you own a house that is worth $100,000 - assume that the market appreciates at 6% (historically is about right) - that house becomes worth $200,000 in 12 years. That means, you made $100,000 in 12 years...pretty good. The difference between the stock market and real estate is incredible due to leverage. You would need $100,000 in cash to buy $100,000 in stock (we aren't going into margin accounts etc.) Now what is absolutely unbelievable, and separates real estate from the stock market, is that you probably bought that house with 25% down or just $25,000 for the same purchasing power. If you had $100,000, you could buy 4 houses for $400,000 and watch the power of compounding kick in. In another post, I'll discuss the ROI of stocks versus real estate. Really cool stuff! Happy Investing.
Scott Benjamin, PhD, MBA
The Absent Minded Professor
I suggest you divide 72 by 9 to get 8.
We also look at the relevance of risks of similar investments drilling a bit deeper into ROI, it's been discussed in the forums.
Since RE is unique, it is difficult to classify RE to other assets and since we have an active RE market we can generally have a sufficient population of comparative investments, which is why I don't compare RE to securities such as stocks or bonds. The liquidity isn't there for RE which pretty much makes RE a zebra without stripes.
The Law of 72 also assumes a constant and uniform compounding, market fluctuations in RE are seldom at an even pace of appreciation in the market. It can be more applicable to notes if they are performing and paid as agreed. The old "Rule of 72's" is older than I am but it certainly works.
BTW, the forums really aren't for a blog series, we have blogs on BP for such information. The podcasts are really something. The BP forums are for the Q&A discussions. Best of luck :)
The rule of 72 has been around for some time (since 1494) but is probably a tool that could still be utilized by many 'buy and hold' investors for estimation purposes. Using the example, 12 years for a rehabber is an eternity though to have to wait for funds to double.
Some issues... the rule of 72 doesn't necessarily account for inflation and the 'doubling' mentioned is in nominal terms. For real estate investments that utilize debt for financing, the 'doubling' in real terms could be longer.
Example, based on the housing price index data, within the last 30 years (between 1984 and 2014), the housing price index increased from 118.73 to 348.88 (193.84% in 30 years or 6.46% per year). So if you bought a house for $118,730 in 1984, the house was probably in the $348,880 range in 2014 with a ‘nominal’ profit of $230,150.
If you however factor in the total interest paid during the 30 years, using an 8.5% fixed rate, the net increase realized in 30 years is not $230,150 but $20,224. If you were to add inflation also to the equation, then after 30 years the very rationality of waiting that long then becomes a serious question.
If 8.5% seems high for a conventional mortgage, mortgage rates in 1984 were in the 13% range (18% in 1981 and still in double digits by 1986). So on a $118,730 property purchased in 1984 you actually spend a total of $328,656 ($209,926 just interest payments) if you were lucky to find an 8.5% fixed mortgage somewhere. Which practically did not exist.
It is however a tool that could be utilized for some types of estimation.
I find that the rule works best when money in a Roth IRA is invested in income producing assets such as note where you buy based on yield. Yield is not a real number but a target. A 15 yield will double your money every 4.8 years if you can keep all of the money invested 100% of the time. Not real but it is a very juicy target. Even a pilot flying his plane is off course 98% of the time but he gets to his destination. In any event, the money coming out the back side is tax free which adds value. I do not use the Rule of 72 in any other type of investment. Cap rates work better on leveraged income.
Always great to use this rule to help determine how fast your money grows.
John Thedford, Real Estate Agent in FL (#BK3098153)
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