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Property investment is really a simple small business. You have income (rent) and expenses (interest on the mortgage, rates, insurance etc). As with any business you have to make a profit to be successful. In real estate there are two ways to make a profit:
1. Rental Profit – the rent received pays all of the expenses and leaves some cash over every week.
2. Capital Gain – when you sell the property this is the sale price less your original purchase price.
Ask any experienced property investor and they will tell you that you get wealthy from capital gains. The rental income mainly lubricates the wheels and sometimes puts a bit of cash in your back pocket every week.
Obviously, the best scenario is a good rental profit coupled with big capital gains. However, the next best option is a zero rental profit (or even a small loss) with a big capital gain. The least attractive is a rental return with little or no capital gain. Of course the absolute worst is a rental loss and little or no capital gain. You may as well dig a hole in your garden and pour money in. But if you are prudent you will never purchase such a property.
The Property Market is Cyclical
This is so obvious you would think that it doesn’t need to be said at all. But the truth is that even experienced property investors forget this basic principle. When the property market is dead cold, no-one wants to buy. Many parts of the Western world were like this in the mid to late 90’s. It was absurdly easy to buy a property with a high Rental Profit. But the market hadn’t moved and wasn’t moving and no-one seemed interested. Of course if you had bought property at that time you would have made a killing if you had sold into the recent boom.
Of course the opposite is true in boom markets. Prices are going up fast, sometimes 20-30% a year and Moms and Dads are making huge capital gains (on paper), which far exceed their wages or salary. In these times people think that property prices will keep going up forever. They borrow more and buy more, getting a psychological high every time they look at their property portfolio spreadsheet. They forget that the cycle will go full circle and price rises will stop and even decline (yes they fall!). The time will come again when the banks slow their lending and people lose money and then almost everyone goes cold on property.
Simply put you make much higher capital gains when you are counter-cyclical, i.e. you buy in the bad times and sell in the boom times.
The main reason you can make a lot of money in property is leverage. Leverage is simply using a small amount of money to control a large amount of money.
For example, let’s say you have saved (or can somehow get your hands on) $30,000.
1. You can bank it and get 4% interest from the bank, less tax, let’s say a 3% return. So you get $900 a year.
2. You can buy stocks where the average annual gain might be 8%. So you get $2,400 a year.
3. You can leverage your money by going to the bank and getting a 90% mortgage on a $300,000 property i.e.
Assuming conservatively that you have a zero rental profit (rent covers expenses but nothing left over), but that the property value increases by 10% a year:
$30,000 - 10% increase in value.
Therefore, the return on your $30,000 is 100% per year – fantastic!
As I said on the Passive Income page, you do the vast bulk of the work before you buy. I recommend really understanding the market and location. I strongly suggest viewing 100 properties, putting offers in on three and buying one!
As I said above the property market is cyclical. It is far better to buy in bad times when property prices are low.
Most of the Western world has had an unprecedented boom in property prices for the last ten years. I am currently NOT buying property. I am waiting patiently for property prices to really fall. It might take a few years but when they do fall, cash will be king, and I will be ready.
Real Estate Book
I have written a book on Real Estate entitled "Creating Property Wealth". I will be launching it in 2011.
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