How much is bad advice costing you? Too Much!

About a month ago I met a new client of mine, a very smart young guy. He bought his first real estate property 3 years ago for about $175K, put some ’sweat equity’ into it, and it’s worth about $250,000 today. My mortgage broker Jeff Reitzel had an approval in hand to refinance the property, pull out $100,000 to re-invest - while keeping the new mortgage payment less than the potential rent the home will generate (meaning it will ‘cash flow’). With this equity, my client could acquire up to $800,000 in property by leveraging the equity, while still keeping a healthy reserve fund (a must for clients I work with).

My client is 28. He had set a goal a few years ago to own three properties before his thirtieth birthday (great goal!), and he is in a position to make that happen. Unfortunately for him, he is getting some bad (but well intentioned) advice which may have a big impact on his net worth down the road.

From what I understand, the professionals (banker, lawyer, accountant etc) he employs are not real estate investors. Their advice to him is to refinance the property, but only take out half the equity available (40K actually), and use that as a down payment to purchase one property. The rest of his equity will be earning next to nothing for him sitting in the (now) rental property. Failing to invest that extra equity will have a six figure impact on his portfolio in the future. They justified this to my client by explaining that with his net worth he shouldn’t ‘take a risk’ and buy more than one property - even though he can conservatively (i.e. 20% down, and with a reserve fund) afford more.

My client has increased his equity significantly since he bought his first property in 2004 - no other investment he owns or has owned comes (remotely) close - yet it’s a risk to acquire more of it ? This logic sounds funny to me.

Here is what my client can do: Pull 100K in equity out of his current real estate property, and use $80,000 for down payments, keeping $20,000 as a reserve (or ambien) account. If we use a conservative 20% down payment rate, my client can acquire up to $400,000 of property in a growth region with high rents, like Kitchener Waterloo, Ontario (scenario 1).

If we use a more aggressive strategy aimed at accelerating equity growth, we can put 10% down and acquire up to $800,000 of cash flowing real estate investment property in Kitchener Waterloo (and for a reminder of why, look at the Top 10 Reasons to Invest in Kitchener Waterloo Real Estate). We’ll call this scenario 2.

Here is what his accountant wants him to do: Pull out $40,000 (instead of $100,000) in equity and buy a property for $200,000 (scenario 3) with 20% down, and wait a few years. This will be scenario 3.

Say the investment property appreciates 20% in value - not in a single year, but over a few years, let’s say four (so we’re going to estimate a conservative 5% projected appreciation a year) - how much have your new investments earned you in new equity?

In scenario 1, your $400,000 of cash flowing real estate investment property appreciates $80,000.

In scenario 2, your $800,000 of newly acquired property appreciates $160,000

In scenario 3, your $200,000 property is now worth $240,000, appreciating $40,000.

Don’t get me wrong- 40K is a good return on an initial investment of 40K. It’s just so much less than the $160,000 gain on an initial investment of $80,000 in scenario 3.

So, after 4 years, the investor may be out 100K of potential growth, give or take twenty thousand dollars. That’s not where it gets ugly.

When he goes to re-invest the profits he’s made, he has much less equity in Scenario 3. Since the client is still in his early thirties at this point, an extra hundred grand invested can mean a significant difference in his net worth in 20 years when he retires - yes, in his early 50’s.

He can leverage his 160K into around a million dollars of additional real estate property. His 40K will only buy him another $400,000. Now look at 20% appreciation on that amount. When you do the same thing again in 5 years, the numbers start getting big.

Moral of the story: Take real estate investment advice from real estate investors - as many as you can find. If your accountant only owns one house, she might not be the right person to advise you on how to grow a real estate portfolio.

For a free consultation on how you can maximize the growth of your wealth, call me at 519 570 4447

Benjamin Bach Cartoon