AMORTIZATION IS A BEAUTIFUL WORD
It puts money in your pocket.
ONE WAY TO PUT MONEY IN YOUR POCKET
Owning an apartment complex can put money in your pocket.
Hopefully, the complex will cash flow each month, creating a steady stream of regular income.
But, there is another way your complex puts money in your pocket.
If you have a loan on the property and are making payments on that loan, payments that include both interest and principal, then every payment will be paying off the loan with the principal payment.
Now, this is not cash flow you can spend immediately.
Over time, though, the principal payments add up. They increase the equity you have in the property.
Remember, equity is the difference between the total value of the property minus the outstanding debt on the property. When you sell or refinance the property, this is your profit at the sale.
The value of our equity in our apartment complex can grow while we own it, simply by making payments on the loan. The total debt on the property is reduced, with the net effect of growing our equity.
Take this example: If we initially invested $1 million of our own money and took out a loan for $4 million to buy a $5 million apartment complex, we would have $1 million in equity assuming the value of the property remains the same.
The total value of the property may rise because of appreciation, but let’s assume in this article that the value of the property does not change. It remains $5 million for the life of the property. Even though the total value doesn’t rise, our equity can grow because of amortizing the loan, reducing the debt.
Assuming our payments include both principal and interest, every time we make a payment, we are paying down the principal or balance on the loan.
Paying down the loan over time is amortization.
One of the nice elements of investing in real estate is being able to borrow money to purchase it. In the above illustration, we were able to borrow $4 million of the $5 million price of the property.
We borrow money from the “banks,” often with agency funding from Freddy Mac or Fannie Mae.
These loans are often amortized over 20 or 30 years. This means the loan is paid back over 20 or 30 years. The principal part of our payment reduces the total debt with each payment. The rest of the payment is the interest we pay the bank for making the loan to us.
Each month we make a payment on these long-term loans. Month after month after month. Part of the payment is an interest expense and part is the paydown of the principal owed. Make sense?
The money to make these payments is from the income we receive from renting the apartments to our residents. In essence, the residents are paying down our loan each month. These payments on the loan are a quiet and often invisible way our equity is growing.
IT ADDS UP
In the early years of the 30-year, 6% loan of $4 million, the amount of principal is not much, about $4,000 per month. But, it adds up.
By the end of the first year, we have paid down approximately $50,000 of the debt. Another way to look at this is we have increased our equity by $50,000 in one year.
By year five, the debt will have been reduced by $278,000. This means the equity in the property has increased by $278,000 assuming the property is still worth $5 million, our purchase price.
By year twenty of our ownership, the loan will have been reduced by $1,840,000. In other words, our equity will have increased by over $1.8 million simply by paying down the debt over time.
And, at the end of the loan, by year thirty, we will have paid down the full $4 million of the loan.
Little by little, it is like putting wads of hundred-dollar bills in our back pocket. We don’t see it until we sell or refinance the property but our equity has been growing month after month after month.
Over 30 years, amortization has increased our equity by $4 million without any change in the value of the property otherwise. Pretty powerful, wouldn’t you agree?
This was a simple illustration of how amortization increases the equity we have in the property – one of the wealth-building aspects of owning leveraged real estate investments.
We have some friends, whose approach to owning apartment complexes is to keep them for a long time to allow amortization to work for them.
HELP US GET TO KNOW YOU BETTER
What are some reasons that you may have for seeking real estate partnerships? Would you like to take advantage of amortization as you grow your net worth?
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Harland leads our Investor Relations. He is a “repurposed” Pastor and Army Chaplain. He is an author, speaker, mastermind facilitator, and coach. Harland lives with his wife, Barbara, in DeLand, Florida.