04 Oct Slow & Steady Wealth Building: A Case for Holding Long Term Rentals
“The road to success is not to be run upon by seven-leagued boots. Step by step, little by little, bit by bit — that is the way to wealth, that is the way to wisdom, that is the way to glory.” I believe this applies to owning rental property as well. It is not a get-rich-overnight scheme. It takes educated investing and persistence to accrue wealth as a buy and hold real estate investor. However, when you analyze the numbers, the longer that properties are owned, the more likely you are to accumulate wealth.
Have you ever met somebody who has owned a portfolio of rentals over years and years? Chances are, if you are a real estate investor, you’ve rubbed shoulders with other men and women in the industry who have consistently owned and rented properties. How many of them were hurting for income? Probably none of them. The reality is that the type of person who has the resolve to build a portfolio of rental properties is typically wealthy. Let’s take a look at why this is.
Principal Pay Down Accelerates the Longer You Pay on a Loan
Perhaps most of you realize this, but I still feel like it is often overlooked when running a pro forma. The amortization schedule of a mortgage is structured so that the principal portion of the mortgage payment increases every year as you get closer to maturity.
For example, a $100,000 purchase with 25% down payment would be a $25,000 down payment and a $75,000 loan. In the first year of your loan, you will only have paid $1,180 towards principal (meaning your loan balance would be reduced by that much). However, every year that passes, the principal portion of the loan payment will increase. By the tenth year of the mortgage, the yearly principal portion of the mortgage has increased to $1,849. By year 20 it jumps to $3,046, and by the last year of the mortgage, almost all of your payment is going towards principal pay down.
For investors who hold properties for the long term, you can see how mortgages that have seasoned for many years begin to accrue equity at an accelerated pace the closer you get to loan maturity.
Even at a Constant Rate of Appreciation, Equity Accumulation Grows at an Increasing Rate
Equity (attributed to principal pay down) increases at an accelerated rate because of the way amortization works (as discussed above), but equity also increases at an accelerated rate because of appreciation. Now, some will argue that you shouldn’t bank on appreciation when buying property, but I simply disagree. If you look at long term trends, property always has and always will increase in value. Yes, there are dips and market cycles, but over the long term, property general appreciates.
For the sake of this argument, let’s say that the market you are buying in has seen a 3% appreciation rate over the long term. Even at a constant rate of appreciation, your yearly value increases are not constant, they are steadily increasing. For example, if you buy a $100,000 property and it appreciates 3% in the first year, your property will be worth $103,000 in the second year (an increase of $3,000). However, in the second year, that 3% appreciation applies to $103,000 now which would equal an increase of $3,090. More than the value increase in the first year. By year ten, the property is worth $130,477.30, and in that year the property increased in value by $3,914 (compared to only $3,000 in the first year).
Again, when you see this principal play out over 20 and 30 years, the equity accumulation becomes much more dramatic. By year 20, the property is worth $175,351, and by year 30 the property is worth $235,657. Interestingly, by the last year, your property has appreciated over $7,000 in just one year.
I realize these types of numbers can make your head spin. The basic gist of this argument is that the longer you hold a property and pay down a mortgage, the faster the rate of your equity accumulation. It takes patience and persistence, but as you see above, things really start to pick up by year 20. You start clipping away at large chunks of principal, and the property you bought 20 years ago is worth a lot more than what you originally paid for it.
For those of you in your 20s and 30s, building a portfolio of rental properties now can truly become your retirement. For those who are a little older, these same principles can be applied to shorter term loans (i.e. 10 and 15 year amortization schedules).
How about you? Are you disciplining yourself to buy properties now that can be held for massive equity (wealth) accumulation over the long term?