Real Estate Investing and Compounding Interest

I am constantly reading books on real estate investing, marketing and other similar topics that interest me. Right now I am reading Warren Buffet Wealth by Robert P. Miles. In the book, there is a section where Warren Buffet addresses compound interest. He poses a hypothetical scenario, where if Queen Isabella, instead of investing $30,000 in Christopher Columbus’ scheme of charting a new passage to Asia, had invested in anything else that provided only a 4% compound rate of return, she would have made $2 trillion by 1963. In 2003, her investments would have been worth $9.6 trillion, which, according to the author, is more than the value of all the publicly traded stocks in the same “new world” that Columbus stumbled upon some 500 years ago.

Why am I sharing this with you? Because one of the benefits of investing in real estate is the compounding effect that comes from long-term appreciation. Let me explain.

To make the discussion easier, let’s make an overly-simplified assumption. Let’s assume that all the income you receive from your rental property exactly equals all your expenses for that property. In other words, we will assume that there is never any positive or negative cash flow. For our discussion, the house always has break-even cash flow.

If you purchased a house for $100,000 where all the income from the property paid for all the expenses of the property, what happens to the value of that property over time?

History has shown that, despite short-term downward fluctuations, real estate tends to go up in value over time. In Warren Buffet’s example, he used a 4% compound rate of return. Historically, real estate has gone up between 6% to 7% per year, but let’s use Warren Buffet’s 4% growth rate for this exercise to keep our numbers conservative.

If the value of your house were growing at 4% per year, what would the house be worth when you paid it off in 30 years? It would be worth approximately $311,865. At the 30 year point, when your mortgage has been paid off, you will also have a nice monthly income from the property.

This appreciation is one of the things that attracts investors to real estate as a long term investment. If, in 30 years, when you are preparing to retire you want to have a certain amount of money, you can calculate how many houses you need to purchase this year with break-even cash flow to achieve that goal.

For example, if you wanted to end up with $2 million in net worth 30 years from now and you think real estate will be going up in value by 4% per year, then you would need to purchase approximately $642,000 worth of real estate today. If houses in your area are $100,000 that would be about 7 houses. If houses in your area are $200,000 then that’s about 4 houses.