A Broker’s Guide to Investing in Real Estate
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Photo Courtesy: Peter Savio
Peter Savio’s Seven Creators of Wealth
By Dennis Hollier
Peter Savio, one of Hawaii’s biggest and best-known real estate investors, offers these seven steps to wealth.
“I’m going to tell you how wealth is created in real estate,” Savio says. “If you understand these principles, you’ll know why you want to buy real estate. You’ll know how you can make money when the market is going up, and when the market is going down, because you’ll know where the value is being created.
“Just to put this in context: When I first came into real estate 40 years ago, the house was a brand-new, three-bedroom, two-bath home in Hawaii Kai for $25,000. It was unaffordable. People couldn’t qualify for the loan; they couldn’t save up the down payment, which was an astonishing $2,500; and the monthly payment was an unaffordable $250. Forty years later, that same house is worth $600,000 to $700,000. It was a real struggle to buy that house, but the people who bought it, if they managed their wealth correctly, they’re multimillionaires.
“So, what are the creators of wealth?
“The first wealth creator is the concept of appreciation. That’s the one everyone knows. To use our Hawaii Kai example, our house went from $25,000 to $600,000, so it increased in value $575,000. Almost everyone will tell you we buy real estate because of this appreciation. But that’s not true. Appreciation is simply not the greatest wealth creator; it’s superceded by one of the others by five, 10, 15 times.
“The second wealth creator is the savings account called mortgage. When you think about it, your mortgage is basically a forced savings account. If you take out a $400,000 loan, you’re making a legal promise to save $400,000 over the next 30 years. It’s like a giant piggy bank.
“The next wealth creator is the constant monthly payment. The constant monthly payment is the fact that, when you buy real estate, in effect, you lock in your biggest one-time expense – housing – for 30 years. So, as rents go up, your mortgage payment tends to go up much more slowly. (Although your mortgage stays the same, your insurance and taxes still go up.) So, the person who bought that house for $250 a month in Hawaii Kai, 30 years later is probably only paying $300 a month. But the person who rented for $200 a month because he or she couldn’t afford the $2,500 down payment or the $250 a month mortgage is probably paying $2,000 a month in rent now.
“The fourth creator of wealth is the ability to prepay on the principal on the loan. A lot of people don’t realize that, if you make additional payments on the loan every month – or even just occasionally: $50 here, $100 there, take your $2,000 tax refund and pay it on your principal – it will actually save you tens of thousands of dollars in interest. If you pay an extra $50 or $60 a month, you could take a 30-year loan and bring it down to a 15- or 20-year loan, which means you could save $70,000 to $80,000 in interest. You’re making money by paying it off sooner.
“The next wealth creator is tax savings – the fact that, when you buy real estate, the federal government gives you certain tax advantages. The government subsidizes you anywhere from 15 percent to 25 percent, let’s say, in terms of your monthly payment. So, if you’re renting for $1,000 a month, and struggling, you can probably buy for $1,250 a month and be in the same position. A lot of people don’t understand, that when you pay rent, you’re actually paying twice: You pay rent to the landlord of $1,000, but you also pay $250 in additional taxes to Uncle Sam.
“The sixth creator of wealth is the concept of leverage. Basically, in real estate, you can control a valuable asset for very little cash. Let’s assume you buy a property for $100,000, and you put 10 percent down. That’s $10,000. If you had that $10,000 in the bank at 2 percent, you’d be earning $200 a year. If you take the same $10,000 and buy that $100,000 property and it appreciates the same 2 percent, you earn $2,000. Which deal do you want? Leverage allows you to magnify the return.
“The seventh wealth creator is more complex and it’s going to confuse the hell out of you. Because of the way mortgages are amortized, in effect, when you make principal payments, you’re actually receiving interest, tax-free, on the principal you’ve paid. That’s because, although the amount of your mortgage payment is fixed, each month the amount of interest you pay goes down, and the amount of principal goes up. That’s because you only pay interest on the principal you still owe. Let’s say you borrow $212,400 at 5 percent with a 30-year amortization. Your monthly payment of $1,140 is constant for the whole 30 years. On your first monthly payment, you pay $885 in interest and $255 in principal. The next month, your interest goes to $883, and your principal goes to $257. That extra two dollars added to your principal payment amounts to 5 percent annual interest on the $255 in principal you’ve already paid, tax-free. Every month, this amount goes up, so that, on the last payment, in 2040, you still pay $1,140, but your interest payment is just $5, and your principal payment is $1138. Basically, you’re just paying that to yourself.
“The wealth creators are the same whether you’re buying a home or investing. But, on the investing side, the tax savings is even greater. That’s because, in addition to being able to deduct the interest, the property taxes, and the mortgage insurance, if any, you now get to deduct the maintenance, the advertising, the repairs, even the gas you use to drive over to check on the unit – all the expenses you get to deduct because it’s a business.
“On top of all those deductions, the government also tells you that, by law, your unit is losing value because it’s getting older. So, you depreciate it on your taxes, which gives you another three, four, five thousand dollars. So, the investor has an eighth and ninth wealth creator: additional tax savings and depreciation.
So, of all those wealth creators, which one do you think is the most important? The greatest wealth creator is the constant monthly payment. Because you’ve locked in your rent, as your income goes up, you can use that money to buy stocks, buy bonds, save up and buy real estate, pay off your loan sooner – it will all create wealth for you.”
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