Today on Financial Freedom Friday, Matt dives into the math behind real estate investing and wealth creation. Learn the exact equations that explain why real estate brings epic wealth, what makes real estate more powerful than any other industry, and how to become wealthy in real estate.
What You Will Learn About How to Become Wealthy In Real Estate:
- How real estate works and why it creates wealth
- What makes real estate more powerful than any other industry
- How to create wealth for a legacy
- How to leverage other people’s money
- The exact math and equations behind real estate investing
- What the ROI matrix is and why it’s important
- Why you should never judge the performance of your real estate off of cash flow alone
- How to become wealthy in real estate
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Speaker 1: This is Theriault Media.
Matt Theriault: Hey, this is Matt over at Epic Real Estate and welcome to another episode of Financial Freedom Friday.
Speaker 1: It’s time for Financial Freedom Friday with Matt Theriault.
Matt: So, the question that came in this week was how do you get wealthy with real estate? How does real estate create wealth? Good question, very general, maybe basic but I don’t think the answer is basic. I don’t think a lot of people understand or realize how real estate actually works, how does it create so much wealth, how is it so much more powerful than any other industry or any other investment vehicle out there? Why does it create more wealth for more people than anything else? Well, that I want to answer for you.
Let’s be really simple about how this is going to work because a lot of people think, you just come in, you buy a house low and you sell it high and you put $40,000, $50,000 in your pocket and you just got to do that a bunch of times, that’s how you get wealthy. You can make a lot of money doing that, and a lot of people who have. There’s a lot of people that I don’t know that have made a lot of money doing that. But it can make you rich certainly. The pay is really good. It’s really good paying work.
But what we’re talking about today is wealth. How do you create this wealth that can last your lifetime and beyond your lifetime and support generations to come and really create a legacy for yourself. Let’s just look at this. We’ll start with the basic principle of economics and that is … You probably heard this before, nothing groundbreaking, supply, and demand. This is the basic economic principle that runs the economy. It doesn’t matter what industry. It doesn’t matter what product, what service it is, supply and demand.
Inside of real estate, what represents our supply? Well, in real estate, what represents the supply is a land. Land, that represents the supply and what represents the demand? Well, who wants the land? Who’s going to live on that land? It’s people. Inside of real estate, that’s basically what it looks like. Land, as far as our supply, we’ve got what we got. The earth isn’t making any more land. I guess unless you count the lava flow off of Hawaii or the little island, manmade islands they’re making in Dubai, but other than that, we got what we got.
The supply is fixed. Certainly, there’s a lot of it, but it’s fixed. The demand, the people, how are we going with that? Is that growing or shrinking? It’s growing, right? There’s more people walking in this planet than have ever walked it before. And in fact, in 2007, there were more babies born that year than any other year in history. They’re all, what will that be, by when we’re making this video right now, they’d be 11 years old. That means in 10 years, guess what they’re going to start doing? What they’re going to start thinking about? They’re going to start thinking about buying real estate, right?
The population is growing. Each generation is a little bit bigger than the previous and that just continues to happen. We’ve got more people walking. They’re going to need a place to live so this is a pretty good safe bet. The supply and demand equation, very much in your favor and it’s going to be long after, or for at least as long as we’re walking in this planet.
The demand is growing, supply is fixed. We’re good to go there. This is about as close to a crystal ball as you could have and I think that’s pretty good when it comes to investments. We all want a crystal ball when it comes to investments. I think we’re pretty safe there unless shelter or a roof over our head somehow goes out of fashion. I don’t see any technology coming up and disrupting our need for housing. So, it’s a good safe bet, real estate right from this point forward as long as we’re alive and walking the earth, we’re going to be fine.
There’s supply and demand. Now, let’s look at the second part. Second, you want to draw your concept to something called leverage, and specifically, I’m talking about the leveraging of other people’s money. And I’ll show you how this works. Because this type of leverage is available in real estate for the average person, anybody can go out and do this but it’s not available, this type of leverage is not really available in any another type of investment strategy or investment vehicle for the average person.
If we look at leverage, we got this house. Let’s say the house or the sales price of this house is $100,000. Now, if we want to buy this house, we’re not going to go and give the seller $100,000. No, we’re going to take advantage of this leverage aspect. What we’re going to do is we’re going to leverage or borrow $80,000 and we’re only going to put down $20,000.
We have put this down as our down payment and we’ve leveraged this $80,000, other people’s money in most traditional instances, that will be from a bank. Got it? Now, let’s say that this house it’s going to appreciate 1% per year, 1% per year. I want to keep this ultra-conservative to show you how this works. We’re just going to say 1%. If that appreciates 1%, what are we going to look at in five years? What will this look like in five years?
Well, in five years, this will have appreciated about $5,100. I want to keep this really, really simple and just round it down to make the math simple. This house after five years is now worth $105,000. Basically, a 5% return. Nothing to write home about, but is it really a 5% return for you? For you that put down the $20,000? No, because this $5,000 although the sales price appreciated 1%, you got this full $5,000 on only the money you put in. That’s 25% return. You see that?
It’s 5% on the full price but 25% on your investments. That gives us, let’s see, it gives us 25%. So far so good, right? That’s really good. That’s a 25% return on this 1% appreciation over a five-year term. Now, we’ve got our supply and demand that we know about. We got our leverage.
Now, let’s look at what most people won’t tell you about and I don’t know if they want to keep it a secret. I don’t know if they don’t know but you’re not going to learn this in too many other places but stick with me. Some of this might be a review for you, some of this might not. This is what we call the ROI matrix. When I say we, it means us here at Epic Real Estate. That’s what I call it, and it’s just four quadrants.
Now, this is my second time shooting this video because I got the math wrong and I had to stop and do it all over again. But I started thinking about it was the math isn’t really what’s important that I’m going over here. I got it right now. It’s going to be right, but if it happens to be wrong, don’t get distracted with this whole concept I’m showing you focusing on the math, make sense? All right. I just don’t … I’m putting that disclaimer there because if I get wrong again, I don’t want to shoot it all over again.
But we’re talking about the appreciation. And here’s our appreciation quadrant. There are four profit centers inside a real estate, the four biggest one that you should be paying attention to. And based off of our appreciation, that 1% and then we talk about the leverage, we’ll just keep the same property as an example. That turned out to be 25%, so a 25% net profit center.
Now, let’s look at the next profit center. That profit center being the cash flow center. If this is an investment property, you’re going to rent this property out to somebody for the right for them to use it as their living space. They’re going to occupy that dwelling and they’re going to pay you on a monthly basis for the right to use that property. We call that rent.
Let’s see. Let’s say this house is a $100,000 sale. Rents for … Keep the math again nice and simple. Rents for $1,000 a month. Now, do we get all that $1,000? No, we don’t or it comes to us but now we’re going to pay some expenses for the property. So, we want to deduct 40%. We’re going to deduct 40% and that 40%, just a rule of thumb that you can use for quick and dirty math. It’s going to count for your taxes, your insurance, your vacancy, your maintenance and your property management. Let’s just say that.
That’s going to leave us with $600 a month. That’s our net income. But what do we have left? We have another expense because we leverage the money, right? We borrowed that $80,000 so the payment on that, we have to pay that out of the $600 we have. That payment would be about, keep it simple again, be about $500. So, $600 minus $500, that leaves us … Let’s see, I’m running out of space here. Let’s keep it in this quadrant. That gives us $100 a month of cash flow.
Got it? We got $100 a month of cash flow. If we take that $100 and this is over five years because this is a five-year appreciation. So, that cash flow over five years, so it’s 60. So, that’s going to be $6,000. It will be $6,000. Now, we’re going to divide that by our investment again. This 25% was based off the $20,000 that we put into the property. This cash flow is based off the $20,000 we put into the property. I want to take the $6,000, divide that by the $20,000 and what does that give us? This is, I think … I did the math beforehand just to make sure. And so that’s going to give us a 30% return. Let’s circle it so you can see it.
We got 25% for our appreciation quadrant. We have 30% for our cash flow quadrant. When you’re looking at this two things, this is how most people make their buying decisions for an investment piece for real estate is they’re looking, okay, what’s the appreciation or how much equity they have, how much do I project or my predicting or my guessing that the property is going to appreciate and then how much money is he going to pay me. Most people just look at appreciation but the smart investors, they look at the cash flow and the super smart investor is going to look at both.
But the ultra-intelligent real estate investors that you’re going to be after you watch this video, they’re calculating the other two quadrants as well, the other two profit centers for real estate. So, let’s look at the next one, amortization. I think amortization has one “m”. I’m not sure. Maybe it’s two, but amortization. We’ll just assume that I spelled that correctly. What amortization is that’s the buying down, the paying down of that $80,000 that you borrowed from the bank, the $80,000 that you leveraged. But if this is an investment property that’s paying you the cash flow, are you paying this down? No, your tenant is paying it down.
See, if this was your primary residence, that’s you paying this down, everyone. There’s no ROI for that, for the amortization quadrant. But if it’s an investment property and the tenant is paying it down, good ROI here. You can’t underestimate and you can’t ignore this. The way an amortization schedule works when you’re paying back the bank, they try to get … They don’t try. They do. They get most of their interest upfront and then the principal is paid on the backend. It’s kind of a sliding scale.
In the very beginning of the year, you’re paying this much of the principal and you’re paying all. Almost all of your payment is going to the interest and then that gets smaller and smaller and smaller as you go on year after year after year. The last 29th and 30th year of your mortgage, most of that payment is not going to the principal. But the beginning of the first five years, it’s really insignificant but not totally so let’s look at it. I did the math again. What that would be is … In your first five years of this $80,000 lump only … It’s kind of sad. Most people don’t realize it. It’s really kind of sad … But only $1,800 was actually paid to the principal. The rest of it went to interest.
But you still got $1,800 of your loan paid down. If we go ahead and we take that, what do we going to do? How much money do we put in the deal? We put in the $20,000. We leveraged the $20,000. We got a return on that. Then we’ve put in the $20,000, we got the return on that. So, we’re going to take this $1,800. I’m going to divide that by our $20,000 as well. And what that’s going to give us is 9%. We got 25% in the appreciation quadrant, 30% in the cash flow quadrant, 9% in the amortization quadrant. It’s looking pretty good, right?
Let’s look at the next quadrant. Have any guesses what that might be? The next profit center real estate, depreciation. Yeah, tax deductions. It’s another big profit center. A lot of people fail to calculate when they’re making this buying decision. But this one, it’s significant. You don’t want to ignore this. What’s depreciation? Well, Uncle Sam, inside the tax code, they give you an allowance for the wear and tear on a property. What they’re going to do is they’re going to allow you to take the deduction for the depreciation over the next 27 and a half years. But they’ll only allow you to take it on the actual physical structure on the property itself. You can’t depreciate the land. The land isn’t going to deteriorate but the property or the structure will. Basically, the formula is they’re going to give you 80%. We have that $100,000 property that we paid for. So, we’re going to take away 20% as the land, so $20,000 remove the land. So, we’re allowed to depreciate $80,000. We’re going to divide that by 27 and a half years and that’s going to give us again, see, 27 and a half. That’s going to give us $2,909 deduction each year. That’s pretty good.
You can’t take it all because it depends on what tax bracket you’re in. Let’s say you’re in the 40% tax bracket. Going to multiply it by the 40% and that takes it down to … That was $1,163. Here’s why a lot of people don’t recognize or don’t feel this. They don’t see it is because that’s not $1,163 that your real estate paid you. That wasn’t money that you actually got to put in your pocket. It was money that you got to keep in your pocket. When that tax bill and you’re like, “Not so fast, I have this property and I get to deduct this from how much I owe you.” It will be like $8,900. I’m going to send you $8,900 instead of a $10,000 bill or $10,000.
That’s where most people, it’s not incoming. It’s just money that you get to keep that doesn’t go out but it’s still a return because he didn’t know this property that would actually go to Uncle Sam. Let’s multiply this by five years and that gives us $5,808. Did I say it right? $5,818, sorry. $5,818 and what are we going to do? We’re going to divide that by what? Yeah, the $20,000 that we put in. So, divide that by 20 and that gives us … Are you quicker with the math than me? Let’s see, 29%.
Look at all of this. After five years, you got 25% here. You got 30% there. You got 29% there and you got 9% there. That’s how real estate makes people so wealthy and you add all that up and what you got there is … Let’s find a really good number here, a good color is 93% return on your investment in five years with just a very basic, modest ultra conservative 1%, 93%. Now, if we divide that by five, we’re going to annualize that, that’s going to give us an 18.6% return. That’s pretty cool, right?
Now, I know the stock market has been really good lately and maybe you got lucky and you bought some Netflix and this 18.6% looks ridiculous because you did so much better than that. But is it going to do that next year, or the next year or the next year? Maybe, we don’t know. There’s Amazon or Facebook or maybe you took a chance on a tech stock or something like that but you know the real estate, this is off a very 1% appreciation. I could do this really, really low just to kind of prove this point because if you go back over the last 60 years, real estate has averaged almost 12%, a little hair over 12% in appreciation. I did this just awful 1%.
Let’s say we just went to 3% with this. We just want to 3%. You know what does to this? That changes this to 28% but just by going to 1% to 3%. But we went over the last 60 years, we’ve averaged over 12%. So, hopefully, that gives you a little bit of an insight as to why real estate creates wealth and how it has created so much because you’ve got all these profit centers working. And see, most people will look at appreciation. They’ll look at the cash flow and they just kind of stop with their analysis right there at that point.
And that we hear this all the time a cash flow savvy or turnkey operation where people will buy a property and say, I don’t know, say that water heater goes out. It happens. Water heater goes out and you have to totally replace it. And they’ll look at this like, “Well, I only make $100 a month and the water heater costs me $1,200. That wiped out a whole year of cash flow. This thing was a waste. I shouldn’t even have bothered at all.” No. you’ve got this profit center working. You got this profit center working. You got this property center working.
So, yeah, maybe you lost this 30% for that year but actually, you didn’t because all you do is just adjust the cost basis. This is a capital improvement and, boom, you get it all back. It’s not a loss. Don’t judge the performance of your real estate just off the cash flow alone. It’s important. It’s fun. We want this but you’ve got these other three profit centers that are happening underneath with your cash flow or not. All righty?
That is how real estate makes you wealthy and that is why real estate is the final frontier for the average person to creating epic wealth for themselves. There’s lots of other ways to do it but if you look at the statistics, this is how it’s most likely going to happen for most people. I hope you enjoyed that. I will see you next week for another episode of Financial Freedom Friday. Take care.