Wealthy people share a few things in common, and Iím going to explain them in this article. This may sting a little, so be forewarned. They all view their house as a home, not an investment. Yes, I know that sounds like lunacy to a North American mind. How can something worth so much money not be considered an investment?
Simple. Wealthy people are almost always financially literate and understand the power of interest, the time value of money, and return on investments. Your neighbor next door calculates how much he made on his house like this:
Spent- $45,000 on renovations
Seems straight forward, hard to argue with these numbers doesnít it? In fact, thereís a whole lot of information missing here that could change this calculation. How long did he own the house? How much interest did he pay? What other expenses were incurred besides renovations? Repairs, maintenance, etc. And finally, the time value of money. The $600,000 he received today is worth less than $600,000 when he bought the house.
I used to laugh at this concept, thinking it to be irrelevant. Itís anything but. Let me illustrate.
Year 2001 bought house for $500,000
Year 2004 spent $10,000 on renovations
Year 2006 spent $35,000 on renovations
Year 2007 spent $5,000 on repairs.
Year 2008 sold for $600,000
At a rate of even 2% for inflation, which is only true in fairy tales and government statistics, letís see how this pans out. Weíll take the $600,000 received in 2008 as an example. Iím going to simply regress $600,000 back to 2001 to find out its value and compare apples to apples with the $500,000 paid for the house.
2003 $542, 352
Total gross profit= $20,875
Now we deduct expenses. For the sake of efficiency, Iíve regressed the expenses too, if weíre going to regress, we have to regress all numbers.
$9412 + $31,637+ $4429= $45,478
Now letís run all the numbers.
Purchase $500,000(2001 dollars)
Profit after sale in 2001 dollars. $20,875
Expenses $45,478(2001 dollars)
I havenít factored in realtor fees or interest costs. Both are significant. I increased the value of this house by $100,000 in 6 years, a very healthy increase by anyoneís standards, and still this person lost money. Letís say we remove the renovations? Yes, probably a good idea, but we would also likely have to reduce the sale price as well. The net effect would depend on how wisely the renovations were done. Some renovations add more value than others, and some add no value at all.
This is one example of how sophisticated investors view investments. They know the power of interest and inflation, whereas the average person thinks theyíre too minor to consider. In this scenario, even a puny 2% inflation cost this homeowner $80,000 in potential profit, and I can guarantee you that inflation is more than 2%. How? Easy. What did you pay for milk 5 years ago? 10 years ago? Add 2% per year and see if you come to todayís price. I guarantee you wonít. Use items where inflation is impossible to hide, like milk, meat, and vegetables, and youíll begin to see how high inflation actually is.
Are you beginning to see why wealthy people donít view their home as an investment? Or at best a poor investment? I hope so, it will serve you well in years to come. Imagine is inflation is actually closer to 5%. You donít even want to know the numbers if I work in a 5% inflation figure, nevermind realtor fees and interest costs. This is how banks and large financial investment firms make money, they fully understand the power of inflation and interest.
Now letís reverse the scenario. You can play the wealthy investor instead. I think youíll enjoy this end of the bargain much more.
Letís say you decide to lend money for mortgages and big ticket items, like boats, cabins, and home renovations. Weíll say you lend out $75,000 for a home renovation to a nice couple who want to do some updates to their home. Letís break down the numbers. Weíll use 5% as an interest rate, a very low rate, but these days about average for a loan like this. The loan will be over 7 years.
2001 Loan of $75,000 Monthly payments of $1056.14
2001 Interest(your profit) $3462
2002 Interest $3001
2003 Interest $2518
2004 Interest $2010
2005 Interest $1477
2006 Interest $917
2007 Interest $330
Total Interest Received $10,253 Return on Investment 13.67%
But letís be fair, the time value of money would eat into your profits, but notice your largest interest revenue comes early on, which means you lose less due to inflation. Now inflation is more your friend than your enemy, like it was before. On the flip side, the couple who borrowed from you agreed to pay 5% interest, but in reality they paid in excess of 10% due to compounding interest. I wonder if they would still choose to do their renovations if they knew they would cost an extra $5000-$10,000.
This example is one of the fundamental principles to investing. You have to understand the power of these concepts before you can ever be a successful investor. Most people think investing is all about picking a hot stock and becoming a millionaire. In reality, wealthy people do very little of that. Instead, they will use a concept called leverage if they want to take a risk for an outsized gain. What does this mean?
Leverage is simply borrowing money or using existing collateral to gain access to more money. In our previous example, making 13% is a pretty safe investment, but lending $75,000 isnít enough to make big money, so how can we make serious money with this system? Thatís where leverage comes in. Actually, itís used in many investing models, but weíll discuss this one.
Suppose you are wealthy and have access to money at 3% because you have assets which can be used as collateral. You can access 20 million at 3%. The 3% becomes your expense in this scenario, and your objective is to lend out money at a rate higher than 3%, but maintain a low risk profile on your investments. You discover you can get 5% with very little risk. The 2% becomes your profit, but now itís 2% of 20 million, which is much more than 5% of $75,000. I think you can do some quick math in your head to get an idea how this works.