Four Magic Questions : Part 2

Real Estate Riches: How to Become Rich Using Your Banker's Money
by Dolf de Roos, Ph.D.

(Page 2 of 5)

There is another way of looking at it. Imagine going into the bank, and saying to your bank manager something like: "I want to invest in gold, and my neighbor says that platinum is a good investment, and my kids are really into phone cards and baseball cards, and my husband (or wife) collects antiques, and we want to buy more stocks and bonds, so will you please, Mr. Bank Manager, lend us the money to invest in these things?" Chances are he will laugh you out of his office. And yet if you were to ask that same bank manager for money to buy property, he will look at the situation with interest, as he is generally eager to lend money on property.

This tells you two things about property. First, it is still considered a safe and secure investment. As further proof of this, consider the interest rates charged on various loans. The interest rate charged on real estate loans is less than that charged on business loans, which in turn is less than that typically charged on credit card balances. Clearly, banks exact higher interest rates where the perceived risk is higher.

Second, the important thing to note from the observation that bank managers happily lend money on property (but almost nothing else) is that when you acquire property, you don't even need most of the money required for the purchase! What a dream situation! Think about this for a moment. Banks have the money (oodles of it!) but fortunately do not want to buy property (otherwise what would stop them from buying it all themselves?). And you want to buy property, but don't have (all of ) the money. What a great opportunity for synergy!

This brings us full circle: With $100,000 cash, you can generally buy $100,000 worth of stocks, whereas that same $100,000 cash can buy you $1 million worth of property.

The advantage of this leverage is self-evident. If both stocks and properties went up by, say, 10 percent, then your stocks would have gone to $110,000 (a profit of $10,000), meaning that you would have made a 10 percent return on your invested capital. Your property would similarly have gone from $1 million to $1.1 million (a profit of $100,000), meaning that you would have made 100 percent return on your invested capital.

Of course leverage works in both directions. If everything goes down by 10 percent, then the stockholder would only lose 10 percent of his invested capital, whereas the property investor would lose all of it. However, I will show in the next chapter why I am not overly concerned with this risk of a downturn.

Question Two

The moment you buy your $100,000 worth of stock using your $100,000 cash, how much is your stock worth?

If Question 1 (from a few pages back) as it relates to stocks draws blank stares during seminars, Question 2 creates discomfort, as most people seem to assume that this time it must really be a trick question. Once more it is not!

By definition, at any point in time, a stock is worth that price at which willing buyers and willing sellers agree to transact a parcel of shares. Even though there may be many tens of thousands of existing stockholders who could be either potential sellers or buyers, and an even larger body of people who could be potential buyers, all of whom may have wildly varying ideas as to what the stock is worth, the market is structured so that at any given time, there is only one valid market price for that stock. Any and all transactions are effected at that one same price until, through the forces of supply and demand, the one price moves to a different level. In other words, at any one time, there is one, and only one, market price for that stock.

Thus, the moment you buy $100,000 worth of stock using your $100,000 cash, it is worth exactly $100,000.

The moment you buy your $1 million property using your $100,000 cash and a mortgage of $900,000, how much is your property worth?

Answers to this question tend to be somewhat guarded, but from an audience there is generally a muted consensus that the property is worth $1 million the moment you buy it.

Well, let me just toss some ideas your way...

Is it not possible that the property for which you just paid $1 million using your $100,000 cash and a mortgage of $900,000 is only worth $650,000, and that some fast-talking owner or agent talked you into paying too much for it? Is it not possible that you bought a lemon?

Of course it is! It happens all the time. Just as people can pay too much for a used car, only to find out later that there is the proverbial sawdust (or banana skin) in the gear box, and just as you can talk yourself into believing that a painting is a steal because you think it is a Rembrandt, only to discover later that it truly was stolen, or that it was a bad copy and therefore not worth 10 percent of what you paid, so too can you pay too much for a property.

By the same token, is it not possible that the property for which you just paid $1 million using your $100,000 cash and a mortgage of $900,000 is worth $1.5 million, and that some slow-thinking owner or agent let you get away with paying too little for it? Is it not possible that you bought a phenomenal bargain?

Of course it is! It happens all the time. Just as people will sell you a car incredibly cheaply because "we are leaving town tomorrow and just want to cross it off our list," and just as you can get a painting for a song because the owners inherited it and never liked it in the first place and didn't think it was worth much, and you then find out it is a master after all, so too can you get a property for what seems like a steal.

Copyright © 2001 by Dolf de Roos, Ph.D.

About the Author

Dr. Dolf de Roos began investing in real estate as an undergraduate student. Despite going on to earn a Ph.D. in electrical and electronic engineering from the University of Canterbury. Dolf increasingly focused on his flair for investing, which has enabled him to have never had a job. He has, however, invested in many classes of real estate (residential, commercial, industrial, hospitality, and specialist) all over the world.