When Miranda and I began our investing journey, we had zero financial education and had no idea how to get started. Like many of you, we had spent many years educating and training in our specialties but never had never learned the basics of finance and investing. As we were getting started, one of the most fundamental and useful things we learned was the equation: Wealth Growth = (V A L T) x WLI.
This means that your wealth will grow commensurate with the amount of Velocity, Arbitrage, Leverage, and Tax deductions you use. We added on the whole life insurance (WLI), as we’ve also learned to utilize this vehicle to further accelerate our wealth.
In this post, we will examine each of these factors separately:
- Velocity and compound interest
- Interest rate arbitrage
- Real estate tax deductions
- Whole life insurance
We will discuss how each of these factors works, and provide an example of how it can be used to help you grow your wealth.
The first factor that can help investors grow their wealth is the combination of velocity and compound interest. Velocity refers to the rate at which money is circulating through the economy. When money is invested, it can generate a return, which can be reinvested to earn additional returns. This is known as compound interest. The faster money can be reinvested, the more quickly it can accumulate.
One way a multi-family investor can utilize financial velocity is by reinvesting their cash flow rather than pocketing the money. For instance, consider an investor who purchases a multi-family property for $1 million and collects $10,000 per month in rental income. After accounting for expenses such as mortgage payments, property taxes, and maintenance costs, the investor may be left with a monthly cash flow of $5,000.
Rather than pocketing the cash flow, the investor could reinvest it into another multi-family property or other cash-flow producing investment. By doing so, they could generate additional rental income and further increase their cash flow. Over time, the investor could accumulate a portfolio of multi-family properties, each generating cash flow that can be reinvested into additional properties.
This is one of the reasons we suggest treating your investments like a business and keeping your investment gains in a separate account. This allows you to keep track of your gains and get them reinvested as soon as possible. Our goal is to keep our investment accounts continually turning as we reinvest our profits as soon as we can find another investment opportunity.
Interest rate arbitrage is another factor that can help investors grow their wealth. This strategy involves taking advantage of differences in interest rates between two or more investments. By borrowing money at a lower interest rate and investing it in an asset that generates a higher return, investors can earn a profit.
Consider an investor who wants to invest in a multifamily syndication that pays an 8% return. However, they can borrow money from their 401k at a 5% interest rate. By borrowing $100,000 (at 5%) and investing it in the multifamily syndication, the investor will earn $8,000 in returns. After paying back the 401k and the annual $5,000 in interest, the investor will have earned a profit of $2,000. This is an oversimplified example, but the concept is sound and we’ve used it successfully ourselves!
Leverage is another strategy that can help investors grow their wealth. It involves borrowing money to invest in an asset, with the expectation that the returns earned will be greater than the interest paid on the loan. This strategy can be particularly effective when investing in real estate, where the value of the property is likely to increase over time.
To illustrate how leverage can increase investor returns in multifamily real estate, consider the following example.
Option 1: The investor can purchase the property using all cash, with no financing.
Option 2: The investor can finance the purchase with an $800,000 loan, and use their $200,000 in cash as a down payment.
Option 1: If the investor purchases the property with all cash, their annual return would be equal to the property’s annual NOI, or $100,000. This represents a 10% return on their $1 million investment.
Option 2: If the investor finances the purchase with a $800,000 loan and a $200,000 down payment, their annual return would be equal to the property’s NOI minus the cost of the loan. Assuming an interest rate of 5% on the loan, the cost of the loan would be $40,000 per year. This means that the investor’s annual return would be $60,000 ($100,000 NOI – $40,000 loan cost), or 30% return on their $200,000 investment.
As you can see from this example, leveraging can significantly increase an investor’s returns on their investment. In this case, the investor’s returns increased from 10% to 30% by using leverage to finance the purchase of the multifamily property. While leveraging does come with risks, including the risk of default and the potential for increased interest rates, it can be a valuable tool for investors looking to build wealth and achieve their financial goals in multifamily real estate.
Real estate tax deductions are a valuable tool for real estate investors who want to minimize their tax liability and maximize their profits. These deductions allow investors to write off a variety of expenses related to owning and managing a rental property, including property taxes, mortgage interest, repairs, and depreciation.
To illustrate the benefits of real estate tax deductions, consider the following example. Suppose that an investor owns a rental property that generates $40,000 in rental income per year. The investor has $10,000 in expenses related to the property, including mortgage interest, property taxes, and repairs. Without any tax deductions, the investor would be taxed on the full $40,000 of rental income, resulting in a tax liability of approximately $12,000 (assuming a tax rate of 30%).
However, by taking advantage of real estate tax deductions, the investor is able to deduct the $10,000 in expenses from their rental income, reducing their taxable income to $30,000. This results in a tax liability of only $9,000, saving the investor $3,000 in taxes. Over time, these savings can add up, allowing investors to reinvest their profits and grow their wealth.
Whole life insurance is another factor that can help investors grow their wealth. Unlike term life insurance, which only provides coverage for a set period of time, whole life insurance offers permanent coverage and includes a savings component. The savings component, known as the cash value, grows over time and can be accessed by the policyholder for a variety of purposes, including as a source of retirement income.
To illustrate the benefits of whole life insurance, consider the following example. Suppose that an investor purchases a whole life insurance policy with a death benefit of $500,000 and an annual premium of $10,000. Each year, a portion of the premium is used to pay for the cost of insurance, while the remainder is invested in the policy’s cash value.
Over time, the cash value grows tax-deferred, allowing it to accumulate and compound over time. After 20 years, the policy’s cash value has grown to $200,000. The investor can take loans against the cash value and use the arbitrage to invest in other cash-flowing assets. We’ve done this continually over the past six years. An investor can also chose to access the cash value to help supplement their retirement income. Because the cash value is considered a loan, the investor is able to withdraw the funds tax-free, allowing them to maximize their retirement income and grow their wealth.
Velocity and compound interest, interest rate arbitrage, leverage, real estate tax deductions, and whole life insurance are all powerful tools that investors can use to increase their wealth. When used in combination, these tools can help investors amplify their gains and achieve higher returns on their investments.
Ultimately, the key to success with these strategies lies in understanding how they work, using them wisely, and having a long-term perspective on investing and wealth building.