Podcast: Why Properties Get More Profitable Over Time & the 8th Wonder of the World| Ep. 224

Posted by Ed McKnight on 27/04/20
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Show Notes

What's Covered in the Show?

In this episode, we discuss compounding growth and why small differences in capital growth rates quickly add due to the compounding nature of property price growth.

We also discuss how the combination of compounding annual growth in property prices and rents makes properties more profitable over time, which is why it is important to continue to hold property for as long as possible.

We also mention our upcoming property investors webinar where we will teach you how to get more money from the bank and grow your property portfolio. Sign up to the webinar here.


Transcript of the Podcast

Ed McKnight: Hello and welcome along to the Property Academy podcast. I'm your host Ed McKnight and I'm Andrew Nicol, and today on the show we're talking about compounding interest or specifically compounding growth rates.

Now, this is a very foundational concept within all financial literacy, and it's the idea that if you've got an asset or some savings, and you put it in the bank or you put it in some sort of investment class that increases at a fixed interest rate, so say 5% every year. Then as you hold it or the longer you hold it, the more compounding, the higher the interest you get each year is relative to the first year.

Now we're going to go through some examples just to explain this, but the reason that we want to talk about it, even though most of you will know about compounding interest, is that we always say you want to hold your properties for as long as possible, including into retirement, if that kind of fits with your situation, because the longer you hold it, the bigger and the bigger gains you get.

And one thing Andrew once said to me was that the longer you hold a property, the more profitable it gets. And that's because not only does its value increase at a faster rate in dollar terms, in terms of the dollars you're getting out of that property, but also rents as well. Because if rents are increasing at 3 or 4% a year, again, it doesn't increase in a straight line. It is more of a curve that you see.

It's not that it increases the same dollar amount each year, but it's the same percentage and that's where you start to see a curve. Anything to add there, Andrew, before we get into the numbers?

Andrew Nicol: No. I think we can get into the numbers; I'm going to tell you a quote that I just had to actually look up to make sure I've got this right. And I see that there's actually about eight different versions of this quote, so I don't know how accurate the words are verbatim, but Albert Einstein once said that compound interest is the greatest mathematical discovery of all time.

So a relatively bright man Albert Einstein, and so if you don't think that us rabbiting on is convincing enough, someone much smarter, said this once before.

Ed McKnight: I feel like he may have also said something along the lines of, it's the 8th wonder of the world, but I'm not sure if I...

Andrew Nicol: 8th wonder the world, that's very good that was another version of that quote.

Ed McKnight: Yeah, I've heard that one as well. So, look, we've got a $500,000 property in front of us. We're assuming it's going to increase at 5% every year. So how does this all add up? Well, the first year it's going to increase it 5% which is what would expect 25 grand.

Well, if we now fast forward that to year 15, it's increasing again by 5% on the previous year. 5% increase on year 14 but if you look at that increase, which has about $52,000 once we get to year 14/15 that's actually a 10.4% increase on the original purchase price and that year, because it increased it by 52K odd. And so, what we see is that the longer you hold that property, the more profitable it gets.

Every single year you're getting a higher return in terms of dollar value. So the first year your property might increase by $25,000. It's really good, but it's not the big change that you're looking for. Once you get to year 20 year 30 and you hold those properties for a long time, that's when usable equity starts to really grow.

That's where your wealth starts to really grow and actually, if you compare 5% growth to 7% growth as well. 7% is the growth rate we usually use in Auckland 5% probably somewhere we might use in say Canterbury or Hamilton, something like that. If you compare that again, so we said 7% growth in the first year based on that $500,000 property that's 35 grand.

Now, if you'd go back to year 14/15 that 19% growth by that time. So that's compared to the 10% or 10.4% growth, we said with a 5% growth rate, because that extra 2% keeps compounding to increase that, increase it, increase it further. And so that's why you often want to invest in places that have as high a growth rate as possible.

You might say, well, and I've actually seen some commentators say, well, of course small towns don't actually have that much lower growth rates than bigger cities, and I saw one commentator say it's a difference of about 1% while yes, it might be a difference of one or 2% within a year or just looking at the flat growth rates, but that starts to compound, especially in property, which is a leveraged investment. Sorry, I cut you off before Andrew.

Andrew Nicol: Yeah, I was just going to mention there that Ed, that remembering, of course, this is always a return on what is mostly the bank's money for a lot of investors, if not all of the bank's money. So the growth that you're getting on the purchase price, let's take that aside for a minute.

Let's say your $500,000 investment, of which an investor puts in 20% deposit themselves, they put on $100,000. In year one you're getting 25,000 worth of growth. If you get 5% so you're getting a 25% return on your investment. When you fast forward to year 15 that $52,000 that's 52% return on your $100,000 investment that year. That's amazing.

And that's again, because you're getting growth on your growth. Like if you put money into a savings account that continues to compound that interest. So, the two magical things here are that you're getting growth on your growth, but also that you're getting growth on someone else's money, not your money when you borrow money from the bank, which is really important.

Ed McKnight: And look, I've heard some commentators say to me, Ed, why is it that you worry so much about growth rates and trying to find the best growth rate. And it just comes back again to this concept of compounding growth.

So, look I've just quickly re done my numbers and I'm looking at the same $500,000 property, but in one scenario, it's growing at 5% a year and the other, it's growing at 6% a year. So, by the end of it, year 15 in this case, there is $180,000 difference between the 5% growth property and the 6% growth property. And so, if an investor bought the 6% growth property, a really high growth property, they would be 180K better off in 15 years time, just because they bought the property in a different area of New Zealand.

And we know there are variations within the areas of New Zealand in terms of the capital growth they get. We know that these major cities tend to get more consistent and high capital growth than some of the, some of the smaller areas. And we've talked about where those areas are, and so that's why it's really important to, if you can, identify what areas are the high growth areas and invest in them because although as 6% versus 5% difference, you might say Ed what's the difference is 1% well, over time it's 180 grand worth of difference in this example.

Andrew Nicol: And actually, I think that's really important to remember this is what makes property such a great investment because you're getting that compounding growth, it makes the investment much more resistant or resilient to inflation. And so, you generally speaking, you still have the same purchasing power in the future, if not more, the longer you hold it.

And so, whether or not.it be you're relying on the rental income in retirement or selling off those properties in retirement. You typically can protect yourself much better from inflation eroding your ability to spend the money or purchasing power of the money by investing in something like property.

Ed McKnight: Fantastic. Well, let's wrap it up there, but please don't forget to rate, review and subscribe to the podcast and hey, if you want to learn more about property with Andrew and I, why not check out our upcoming webinar this Tuesday where Andrew is going to share his secrets of how to, well, they're not actually secrets, they're fundamentals.

I always laugh when we start talking about secrets because I think that's such an old school marketing term to use. They're not secrets, they're fundamentals of how to get from two to five properties within your portfolio. Because this was the most asked for topic in the recent survey that we did. So, if you want to sign up for that, we are going to drop a link in the show notes or just head along to Opespartners.co.nz you can check it out there.

Thanks for listening to the Property Academy podcast. I'm your host Ed McKnight and I'm Andrew Nicol, and we're going to be back again tomorrow with even more daily strategies, tactics, and insights to help you get the most out of the New Zealand property market.

Until next time.