Did you know that Albert Einstein declared compound interest to be “the eighth wonder of the world?” He also asserted that “He who understands it earns it; he who doesn't pays it.”
In beginner-level investing, compound interest (also called compounding interest) is often associated with savings accounts. When you keep your money safe in an interest-bearing savings account, you’re essentially earning money on your money; this is called interest. And when you keep your earned interest in the account and start earning interest on the original interest, you’re essentially earning money on the money your money is earning! This is called compounding interest.
But compounding isn’t just for savings accounts; it also works in real estate investing.
In this article, we’re exploring compounding in real estate investing: what it is, how it works, and how you can use compounding interest to grow your wealth exponentially.
Compounding in Real Estate Investing
Compound interest in real estate isn’t all that different from compound interest in savings accounts. As you earn interest from your investments, you reinvest that interest so it can continue to work for you. This earned interest gives you more money to invest, allowing you to increase your earnings without investing more of your own capital.
To see how compound interest works in real estate, let’s consider a beginner-friendly example:
Ana just purchased her first home. This home has a spare bedroom that she doesn’t need, so she decides to rent it out (quick side note: earning income from your home is a strategy called house hacking).
Since Ana can comfortably afford her mortgage payments, she decides to apply the rental income toward paying down her home loan balance faster. This reduces the amount Ana will have to pay in mortgage interest over the term of the loan.
So, not only is Ana earning money from renting out the room (which she uses to reduce her mortgage debt and increase her net worth), but she’s compounding her financial benefit by reducing the amount of mortgage interest she’ll have to pay.
Let’s look at how much money is earned in this example.
Assume Ana’s initial home loan balance was $400,000 on a 30-year-fixed mortgage with a 6% interest rate. If she rents out the room for $800 per month and applies that amount directly to her principal amount each month, she would save…wait for it…$233,806.95 in interest over the term of her loan!
Just as importantly, her mortgage would be paid off 13 years and 7 months earlier than her initial 30-year term. Of course, once her mortgage is paid off, she frees up all the money she was applying toward principal and interest every month, so she can now use that capital for other investments or projects.
It’s also worth noting that, in this simplified example, Ana is not raising the rent at any point. In the real world, she would likely be able to increase the rent every year or two, allowing her to pay off the loan even faster and save even more money.
The Power of Time in Compounding
The more time you give your investments, the greater the impact of the compounding is. Let’s look at the difference compounding in real estate can make over the long term.
Consider two friends, Johnny and Ryan, who each have $100,000 to invest in real estate and both find development projects with annual returns of 20%.
At the end of the first year, they both earned $20,000 in returns. Johnny decides to spend his earnings on a lavish vacation. But he’s going to reinvest his original $100,000 for another year. Ryan, however, decides to reinvest his $20,000 earnings in addition to his original $100,000, giving him $120,000 to invest in year two.
At the end of that year, Johnny has earned another $20,000, which he then spends on a wardrobe upgrade. But Ryan has earned $24,000 this time because he invested more at the beginning of the year. And he decides to add this new $24,000 to the $120,000 he had invested at the beginning of the year.
Continuing at this rate, Johnny will always have $100,000 invested and will always earn $20,000 per year. But Ryan’s returns are compounding. At the end of five years, he’ll have $248,832 invested, and his earnings for that year will have been $41,472.
Skip ahead 15 years to see where Johnny and Ryan are 20 years into their investments. Johnny’s still got $100,000 invested and has earned another $20,000 in year 20. But Ryan…Ryan now has $3,833,760 invested. And his earnings in year 20 alone came to $638,960! Just look at this exponential growth…
When you give compound real estate investments time, you can amass wealth without continually investing more money out-of-pocket. This is a much more sustainable strategy than attempting to buy at the “right time” and subsequently sell at the “right time.” And this is why time in the market beats timing the market.
How to Utilize Compounding in Your Real Estate Investment Strategy
Whether your goal is tobecome a millionaire or to build generational wealth, compound interest puts you on the fast track. And there are multiple options for compounding in real estate. We’ve already looked at house hacking in our first example, so let’s explore some other opportunities
1. Build a Portfolio of Long-Term Rentals
Rental properties offer multiple benefits including recurring cash flows, long-term appreciation, and tax benefits. You can take advantage of compounding by investing your rental income in paying down your mortgage debt faster or using it to acquire more properties.
Buying distressed properties, renovating them, and reselling them is one of the most popular short-term real estate investment strategies. And, when you reinvest your proceeds from one sale to finance the next flip, you can work up to larger and more profitable deals.
What if you don’t have the knowledge base, time, or desire to handle properties? Investing in real estate without buying property is becoming a more common option for those who want the benefits of real estate investing without the hassle.
Take real estate crowdfunding and syndication for example. These are similar strategies in which investors pool their funds to access unique real estate deals that are professionally managed. This allows you to passively capitalize on appreciation, rental income, and tax breaks. And you can use crowdfunding and syndication to invest in the long-term rental and house flips we’ve already discussed, as well as larger projects like multi-family development.
As you receive rental cash flow or proceeds from the sale of one property, you can reinvest those funds to take advantage of compounding in real estate.
Compound Your Returns and Invest Alongside Gatsby Investment
Gatsby Investment is a real estate syndication company that offers a wide range of unique real estate investment opportunities to modern investors. With both short-term and long-term investments to choose from, Gatsby can help you build a diversified portfolio that provides compounding returns to grow your wealth!
