Harnessing the Velocity of Money
The Velocity of Money is important to understand on a micro level just as it is on a macro level. If the faster money transacts in an economy signals strength in the economy, then the speed at which your investment dollars return to you (to be redeployed, of course) signals strength in your personal financial picture, as well.
To illustrate our point, we will look at two examples of people investing in real estate. Conventional Cole buys a primary residence to live in while Investor Ian invests in value-add real estate opportunities.
Conventional Cole buys a nice home for $400,000 where he and his family will live for the next 30 years. He puts down 25%, or $100,000, and takes out a mortgage to buy the property. The bank puts up the other 75%, or $300,000.
Primary residence mortgages are some of the best money available. It’s got a long (30 years!) term, low interest rates (currently under 4%!), and allows Cole to pay down the loan and build equity slowly – but surely. Over the next 30 years, he will pay down that 75% - and see a 300% return on his money, or $300,000 on his $100,000 investment.
But wait, there’s more! Assuming a 2% rate of inflation over these 30 years, his house is now worth approximately $725,000 (without considering higher growth rates in property values).
To sum up, Conventional Cole put down $100,000 and now when he is ready for retirement 30 years later has an asset worth $725,000. His initial down payment returned almost 625%, or around 6.8% annually.
Conventional Cole is ready to hang up his cleats, or his stapler, or his laptop – whatever he’s been using to conquer the 9-5 for the past 30 years. He sells his house and invests the proceeds into a healthy mix of cashflowing stocks and bonds with a yield of 5%. He will earn $36,250 (in addition to social security and/or pension available to him).
Investor Ian takes the same $100,000 and invests it in a value-add real estate deal. Let’s assume he earns 7% “cash on cash” return annually, or $7,000. But because he added value to the deal, he is able to refinance the property after 2 years and gets his full $100,000 back, all the while he still owns the property and will still receive $7,000 (not accounting for any additional increases in rental income).
In year 3, Ian reinvests the initial $100,000 into a second value-add opportunity and again receives 7% or $7,000 a year in income. After two years (year 5), he’s added enough value to refinance this second property and get his $100,000 back, while still earning $7,000 from this second property. He reinvests the $100,000 into a third property producing 7%.
Allow me the liberty of assuming Investor Ian successfully does this for the next 6 years – 11 years in total. Even better, in Years 8 and 11 he’s accumulated enough cash from his properties to purchase an additional two properties.
By the time we get to the end of eleven years, Ian has accumulated 9 properties with equity of approximately $900,000 and producing $63,000 in annual cashflow (not accounting for any increase and/or inflation factor or the hundreds of thousands of dollars of debt that he paid down a little bit every month). Finally, he’s recently accumulated an additional $100,000 cash from these income producing assets.
Of course, these examples are simplified. Investor Ian has to pay personal rent and Conventional Cole might still be investing his hard-earned money. I’m also not specifically against the purchase of a primary residence; I do think the financial benefits are overstated, but that’s for a different post.
The point, really, is that we should aim for a high Velocity of Money. In any investment vehicle, the goal should be to add enough value to get that initial investment (and more if possible) back so that it can be redeployed again. And again. And again.