In the stock market they've learned how to strip the income off of bonds, which they call 'strips', selling them to investors who want income; and to leave the gain in the bonds in derivatives called 'scores' for those who want capital gains. Somehow, both types of investors pay less for what they get because they aren't being forced to buy something they don't want. We can do the same thing with real estate notes.
A long time ago, Will Rogers, a famous humorist, commented that it wasn't the return ON his money that he was most interested in when investing, but the return OF his money. Mr. Rogers apparently didn't understand the power of compound interest any more than most of the general public. Even in our supposedly sophisticated society, most people have no concept whatsoever of the wealth that return ON money can generate.
An extremely important concept to grasp is the 'time value of money'. It's the key to the compounding of wealth and has probably created more millionaires than any thing else. In Genoa, Italy there is a large, prominent statue of a corpulent noble that dates back to the time of the Renaissance. At first, I thought it might be a representation of Christopher Columbus, but I was informed that it was dedicated to the man who first conceived of compound interest. The wealth created by his concept of having interest earn interest by far surpassed all the natural wealth in the new world discovered by Columbus. Here's an illustration.
In 1626 the Dutch West India Corporation bought Manhattan Island from some Indians for $24. Had they instead invested the sum at 8% per annum and allowed it to compound, in 1999, after 373 years, it would have been worth $70,351,280,000,000.
That's more than all the buildings, companies, stocks, bonds, and businesses headquartered or doing business on Manhattan Island. It's enough to pay off the national debt 4 times.
To bring things closer home. Suppose you were able to set aside $100 per month toward your retirement in a tax free Roth IRA account , and to do this consistently without missing a month for 30 years. Let's presume that at the end of that time, you'd be completely dependent upon the income produced by your accumulated savings. How much would that add up to?
It all depends upon the rate of return your money could command. You might just decide to put your money into a nice, safe bank account at 5%. At the end of 30 years, you'd have accumulated $83,673. If you left it in the bank earning the same interest and lived off the income, you'd have to adjust your lifestyle to $697.27 a month.
Suppose that you bought a junk bond portfolio that yielded 12% over the same period. Your monthly income would jump up to $3,530.91. And if you could arrange to get as much as 15% net annual return, you'd enjoy a living standard for the rest of your life based upon $8,763.53 per month. Of course, these yields don't occur naturally. It requires a lot of effort and some risk-taking. But I think you'll agree that it is all worth the effort.
Comprehending the enormous leverage that present value concepts can provide, the entrepreneur is able to structure mortgages to build in compound spreads. This is done much more easily 'outside' normal conventional financing channels.
Financing techniques really come home to roost when they are combined with house purchases and sales. Once a mortgage has been created or purchased, like one of the aforementioned bonds, it can be disassembled and reconstituted in equivalent 'strips' and 'scores' in a number of ways to increase its yield even more.
Let's look at an illustration of how this might work. A few years ago a Trustee in Bankruptcy offered a home for sale in Realto, California. At that time, the prevailing interest rates were 14%. Unfortunately, although bargain priced at $79,000, market rents from the house, would only support an interest rate no higher than 9%. After paying $9,000 down, we bought the house with two mortgages.
The first Deed of Trust in the amount of $70,000 called for payments based upon 9%. The other was a second mortgage that called for a single payment after 5 years in the amount of about $6000, plus 5% interest which would accrue over the period and be added to the principal amount owed.
$6,000 was calculated as the total difference between current 14% market interest rates and our 9% mortgage over the 5 year period. By avoiding high market rates, the house would generate enough cash flow from rents to support the 9% mortgage payments. Anticipated appreciation and rising rents would hopefully generate sufficient funds to pay off the balloon note after the five years had transpired.
If you dissect this transaction you might discover that there was more to this than met the eye. In effect, a fixed rate, fully amortizing 30 year $70,000 loan at 14% would have required a monthly payment of $829.41. The same loan written at 9% required $563.24. That boiled down to a monthly cash flow savings of $266.17. Over a 60 month period, this amounted to $15,970.45, not the $6,000 we were paying.
Furthermore, one would think that at least 9% should have been accruing on the 2nd mortgage, but it only called for 5%; the difference between 9% and 14%. But there's more:
At some point in the intervening five years, the 2nd mortgage loan was sold at a discount to an investor. No demand was made for payment. The sixth year passed. And the Seventh year. Finally, through an intermediary, we made an offer to buy the $6000 second mortgage for $5,880 cash. The offer was eagerly accepted and the money paid over. Why would an offer of 98% be such an attractive proposition for us? What was missing?
First of all, in all probability, the investor had paid far less than this amount when he had originally bought it at discount. He was focused on the spread between what he'd paid and what he was being paid, not the invisible 5% interest that had been quietly accruing and compounding on $6,000 over the prior seven years.
Had the compound interest been added into the amount owed, the unpaid balance would have compounded to $7,657.69. In effect, by paying a total of $5880 for an assignment of the loan, the $6,000 was borrowed with 2% less than no interest at all.
If you recalculate this entire deal, a total of $33,794.40 was paid in over 60 payments on the first mortgage. $5,880 was paid on the second, so the entire cost of financing plus principal payments added up to $39,674.40. During this same period, overall after-tax rents produced enough money to pay for repairs, management, maintenance, taxes, interest, principal, and insurance. At the end of 7 years, the property was sold for a long term capital gain of $34,000. What was the return on our investment?
First of all, because of our mortgaged 'leverage', we didn't invest $79,000. Or $79,000 plus $39,674.40. We invested only $9000 and got back our investment plus $34,000 after 7 years. That boils down to a compound annual yield of 30.45%. It's hard to buy 'mortgage paper' that will yield this much. The yield was produced by the combination of creative debt and 'break-even' management. Being able to deal with an investor who didn't understand the value of accrued interest didn't hurt any. This is a fairly common occurrence.
