Compounding is both shrewd and a cornerstone investing practice.
In broad strokes, it involves earning profit or dividends on both the original investment, otherwise known as the principal, and on returns received.
For compounding to work, an investor needs to reinvest the returns back into an asset be it a financial product or a real estate asset like property. Put another way, in its simplest form, compounding is taking the income earned from a particular asset and re-investing it. The benefit is that over the long term, compound growth can multiply an initial investment exponentially.
When dealing with financial assets such as RRSPs or GICs, an investor can pass off the heavy lifting of compounding by reinvesting earnings automatically. In turn, those earnings add to the value of your account and boost the potential to earn even more. The key? Patience. Don't be tempted to withdraw the funds when they grow.
How Does This Work For A Real Estate Asset?
An investor seeking compound returns from real property may wish to start sooner rather than later, even if they’re starting off small with an inexpensive property. That’s because compounding in real estate isn’t an overnight affair. It is for this reason that real estate is often referred to as a long-term, buy-and-hold investment.
In order to give Canadian Real Estate Wealth readership top-shelf advice, we leaned on Top Investor Agent and REALTOR ®Sandy MacKay who has two distinct added advantages to offer our dedicated readers; he is himself an investor and, he is the leader and namesake of the renowned real estate investment portfolio management company the MacKay Realty Network.
We asked Mr. MacKay if the idea of automation of compounding can be applied to real estate investing and if so, how. Here’s what Sandy shared:
“Everyone should develop their own plan based on their wealth-building goals. Generating income without a model for saving and reinvesting it, will often lead to that income disappearing. The sooner you embrace this reality, the faster you will build wealth. This means you need a plan for the income your real estate portfolio produces. The simplest version of this is to put aside a % of that income to be reinvested back into more income-producing assets. This could mean that for every $100 generated by your rental property, $10 of that is going to be set aside into an account where it will eventually be used to buy another investment property.”
Moving From Landlord To Investor
Another channel by which landlords benefit from compounding is through asset appreciation.
This comes when there is an increase in the value of the property. Although the post-pandemic lockdown drove enormous and, arguably unsustainable property spikes in some markets, it is still reasonable to see incremental growth in real property’s market value.
If property prices steadily increase 5% annually for a period of 10 years, landlords receive a nice boost to their net worth. Additionally, the greater the property prices mean the greater the rental prices, which also helps an investor’s bottom line.
Even landlords who aren’t reinvesting the rental income they receive will benefit from such increases. Provided a trigger rate isn't at play, mortgage payments will stay the same if a fixed rate was used. Anything extra received in rent enables them to accumulate additional wealth, either by putting more money in their pocket or by enabling them to pay off the mortgage sooner.
In order to paint the full picture, here are a few caveats that Canadian Real Estate Wealth would like to put on the radar:
- Cash flow and equity from one rental property are being used for subsequent additional asset property purchases, which has some inherent risks. Read the fine print.
- Growth is measured annually; Investments are being leveraged to generate cumulative profits and growth year-over-year. In another piece, we spoke about the importance of understanding key performance indicators. More information on that can be found here.
- As a general guideline, the long-term increases in property values may outpace cumulative cash flows.
- Consequently, an investor may initially need to pay for expenses from personal savings when a property does not generate immediate cash flow.
- An investor who begins compounding real estate assets sooner rather than later may be able to generate significantly more wealth over the long term than those who wait.
The Dynamic Duo
In a dynamic and agile cash flow strategy, an investor’s goal is to make money primarily from the cash flow a rental property generates.
An investor may also wish to turn their mind to tax benefits like capital depreciation when calculating real estate cash flow. Capital depreciation is a non-cash deduction the Canada Revenue Agency and the U.S. government's Internal Revenue Agent allows a real estate investor to apply to reduce pre-tax income. However, due to its complexity, we recommend consulting an expert in all matters of taxation.
Dreams To Nightmares
While compound interest is like a dream come true for savvy real estate investors, if not closely monitored, it can spell trouble for people, as well. When applied to debt, compound interest can make a bad situation even worse for real estate investors who aren’t attentive to the amount leveraged.
Given his strong real estate investor background, we asked MacKay for his insight on how to avoid financial hot water when it comes to compound interest. Here are a few recommendations that he had:
“Being wealthy is about keeping money, not spending money. Most people don’t get this. They want to spend a million dollars, not have a million dollars. Building wealth and sustaining wealth is not the same thing. Sustaining wealth is all about asset allocation/diversification and patience. If you aren’t patient, then you will open yourself up to a big loss one day which could wipe out all your work up to that point. Become a student of wealth preservation, not just wealth building. “
The key to making compound interest work for you is that compounding relies on the power of time. Start saving and investing early — either in an investment account that earns interest or with an asset that pays dividends that can be reinvested.
If you would like to learn more about how compounding can benefit your real estate portfolio, reach out to Top Investor agent, Sandy MacKay at [email protected] or visit mackayrealtynetwork.com.