Reinvesting earnings is a powerful tool that can help investors grow their wealth, thanks to a phenomenon called compounding. Warren Buffett once said: “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” What is compounding, and why is it so important to investors? Well, we’re going to dig into that here.
What Is Compounding?
The simplest way of explaining compounding is that you are making returns on top of your returns. I’ll use a simple example to help clarify: say you make a $10,000 investment into a bond that pays 8% interest, semi-annually, meaning you receive a $400 payment twice a year. Now, if you just took the two $400 payments, and assuming you don’t care about price changes in the bond, your return is 8% per year. Pretty self-explanatory, right? Well, what happens if you reinvest your first interest payment as soon as you receive it? Your investing base (the amount upon which you earn interest) rises from $10,000 to $10,400 for half the year. Now, if we multiply that by 4% (our 8% interest divided by 2 to account for the semi-annual payment), you now earn $416 on your second interest payment.
The Power of Compounding
That extra $16 may not seem like all that much, but here’s the difference that reinvesting can make over time: if you were to simply take the interest payments you received, it would take you 25 payments to double your money, or 12.5 years. If you reinvest your earnings, it would only take you 9 years instead. If you had been reinvesting for the same amount of time it took to double your money without reinvesting, you’d have made an extra $6,700!
Click on the image to enlarge it.
For investors with a long-term investment horizon, those three extra years can add up. With an investment horizon of 30 years, you’d make about 9.5 times your initial investment ($95,196.27 in profit), whereas if you just took the interest out, you’d receive less than 2.5 times what you initially invested ($24,000).
Click on the image to enlarge it.
Compounding With Stocks
From an stocks perspective, the S&P 500 returned roughly 79% over the past 10 years. If we had reinvested dividends, that changes to 123%, and goes from a 6.01% annualized return up to an 8.3% annual return! (Calculated from 11/20/2007-11/20/2017, Source)
Click on the image to enlarge it.
Compounding is an incredible tool in an investor’s arsenal for growing their wealth. It’s not just useful to purely income generating investments, but to investments that have occasional cash flows as well. The growth power compounding can provide is why AlphaFlow offers its investors the ability to have not just their repaid principal, but earnings reinvested as well.
We’ve included a calculator that you can use to see the power of compound interest!
Disclosure: All data presented here is for demonstration purposes only. Past performance is not indicative of future returns. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Investors should consult with their own legal, financial, and tax advisors. While AlphaFlow strives to make the information in the article as timely and accurate as possible, AlphaFlow makes no claims, promises, or guarantees about the accuracy, completeness, or adequacy of the contents of this article, and expressly disclaims liability for errors and omissions in the contents of this article.
About the author:
Nick Giovacchini is the Client Services Director at AlphaFlow. Prior to joining AlphaFlow, Nick worked for Barclays Risk Analytics and Index Solutions team, working with institutional asset managers to analyze risk and performance drivers of their portfolios. He also was an Account Manager for MarketFactory, a leading technology provider for the FX world.
Nick has a BA in Political Science from George Washington University in Washington, DC.
If you have been looking at the products available for commercial and residential real estate loans, you have probably encountered the term bridge loan before. Unless you’ve had to apply for one, though, you might not realize what bridge loans are or how they are used. These are short-term loans designed to allow borrowers to:
Buy time to line up long-term funding
Close on a property quickly
Purchase a property, improve it, and resell it in a short time period
In the case of investing in bridge loans, the third reason is the most common. These are the loans mostly used by “house flippers”; real estate investors who purchase and rehabilitate properties before reselling them. They represent a great investment opportunity too, and if you are interested in getting into real estate lending as an investment, you need to know how investing in a bridge loan – or portfolios of bridge loans – can provide you with a great return in a relatively short amount of time.
Bridge Loan Features
Before deciding to take the plunge and starting to invest in bridge loans, it’s important to understand the pros and cons, and exactly how these products work for the lender, and by extension, the investor who is investing in the loans.
They have short maturity terms. Loans of this type have terms of 3-24 months, though the usual term for a fix and flip bridge loan is 12 months, with extensions for consideration of extra time required to complete the renovation and sale of a property In other cases, the loans are paid off early if the developer completes the work and sells it before the loan maturity date.
They cover a large percentage of the property value at the time of purchase. Bridge loans are sometimes available to borrowers for up to the full purchase price of the property, namely because the property is generally undervalued at the time of purchase. This puts the borrower in a position to use funds to make improvements and increase the value of the property for resale. Similar to putting a down payment on your home mortgage, borrowers are required to put personal funds into the purchase, to show skin in the game. Borrowers are required to put a deposit of at least 10% of the property value. Common LTV (loan-to-value) values range from 50 to 80%..
Late payment penalties are in place for most bridge loans. If the borrower does not make a regularly scheduled interest payment, then the penalties ensure the investor is well compensated for the tardiness of the payment.
The loan is broken into multiple ‘draws.’ There will likely be milestones set that allow access to portions of the funds as work completes. The first draw is for the purchase of the property itself. Subsequent draws are based on completion of stated renovation work and must be proven with receipts and invoices.
Interest rates are high. In fact, while many consumer home mortgages charge four to six percent, these loans regularly charge seven to twelve percent, in addition to the loan fees levied by the lender. This provides much more opportunity for investors purchasing the interest-paying note. Coupled with the short loan terms, it means you stand to make a high return quickly.
Other Types Of Bridge Debt
If you are looking for bridge loan investment opportunities, it’s important to understand the diversity of the investment opportunities available. Residential bridge debt is one major category of these loans readily available to individual investors. However, there are other types of bridge loans. Some are used by real estate investors operating in the multifamily and commercial space, and others are used by companies buying and developing new facilities for their own use, or as a stopgap while other financing is sought.
Multifamily: Landlords and property investors often take out bridge loans to cover renovations that will allow them to raise rental rates. This provides them with the initial funds they need, and their strategy allows them to realize a return quickly enough to pay the loan back when it matures.
Retail: Investors that plan to hold retail spaces for a short period of time to develop them before resale often use bridge debt to close on the property. They can then make the interest payments for a year or two before selling the property again to cover the final payment.
Industrial: When industrial spaces do not meet tenant needs, owners often use bridge loans to cover the renovations that bring in new entrepreneurial ventures. This allows them to succeed at interesting new industries and start-ups in tenancy.
Office: Similar to industrial uses, office uses can fund renovations. They can also be used to finance the property while it is being filled before it is sold as a fully mature business to another investor.
Hospitality: The last major use of these loans is to stabilize the cash flows of hospitality businesses as they prepare to refinance into permanent debt.
Each of these types of bridge debt brings with it unique risks and opportunities, so it is important to understand the specific types you invest in and to balance your investments.
The Future Of Bridge Debt
These loans have been powerful instruments allowing for economic development to a wide variety of businesses for many years. It’s not likely that will change anytime soon, but what is likely is that there will be fluctuation in the demand for basic residential bridge loans in various states, cities, and neighborhoods. That’s because residential property investment is its own business with its own very local cycles. By diversifying into a range of bridge debt, though, investors can reap the rewards of the high-interest rates while opening themselves up to more investment opportunities in any market.Advance your investing knowledge by understanding the tax implications around another investment avenue: real estate crowdfunding.
With apologies for the admittedly clickbait title, I’ve got a challenge for you, and I think it’ll make you a better investor. I’ll get to it in just a minute, but first, let me explain why you’re not alone in likely doing this.
We all hear diversification is great. “It’s one of the fundamental tenets of investing!,” we’re told. However, as we look at many of our own portfolios, we find that it’s not actually a reality. We all know about the most common benefit of diversification: smoothing out risk (to be specific, unsystematic risk) which leads to maximized returns. There’s another underrated benefit of true diversification though: it corrects for our natural biases.
As Carl Sagan once said, “Human beings have a demonstrated talent for self-deceptions when their emotions are stirred.” It’s usually that which we know best that gets us most excited. We invest in the stocks of companies we know and understand, but those are usually in the same industry in which we work. Often, it’s believing in your own company and putting your retirement account mostly in the same stock. I began my career at Bear Stearns, the first investment bank to collapse in the Great Recession in 2008. I can’t tell you how many senior bankers there lost everything, as they had invested their savings in Bear stock in the belief that they knew the company better than any other and believed it was solid.
We go on real estate crowdfunding platforms to invest in a variety of properties, yet most people have a bias towards deals in their same city/region where they are often already a homeowner. Trophy geographies like Santa Monica and the Hamptons can elicit Sagan’s aforementioned emotions for investors around the world. For most zip codes though on crowdfunding platforms, you’ll find locals disproportionately investing.
Like in so many areas of our lives, it’s important to confront our biases here and question our portfolio decisions. We can rationalize our over-allocations to the familiar, but as Karen Horney said, “Rationalization may be defined as self-deception by reasoning.”
So here is my challenge to you: As you think about your 2016 investment strategies, start by identifying your biases. Have you only invested in places around the country where you thought you yourself would live? Limited your portfolio to places you’ve actually visited yourself? (I remember one investor who has a superstition about not investing in properties whose street started with a vowel…but she did surprisingly well!) Did you stay out of certain cities or states because of how you imagine it or its residents to be, without actually knowing? Avoided sponsors under or over a particular age?
Now, your rules may work very well and be based upon solid evidence and experience. We use heuristics, or mental rules of thumb, to navigate the world every day. If your goal is a truly diversified portfolio, you’re going to have to let go of some of these. Diversification ultimately comes down to a lack of correlation between the investments that make up your portfolio. What might seem like a very risky investment may actually decrease the risk of your overall portfolio if it has low (or even negative) correlation to the other assets in there. See below to see how different asset classes fared by year:
I did this same exercise at the beginning of the year, and found I’d had a bias against Class B apartment building investments. My unverified assumption was that their pop is limited by an inability to go to Class A if they’re too old while also missing the upgrade opportunities in a Class C building. I’m digging in to verify or dismiss this bias. What are some of your investment biases? I’d love to hear about them! As always, you can reach me at Ray@alphaflow.com.
If you enjoyed this post, sharing it on Facebook, LinkedIn or Twitter with the links below is the highest form of flattery. Thank you!
About the author:
Ray Sturm is a leading entrepreneur in financial technology, and is currently the CEO of AlphaFlow. Prior to launching AlphaFlow, he founded RealtyShares, one of the P2P industry’s top platforms for real estate investing. His early career in finance included investment banking at Bear Stearns, restructuring at Lazard Frères and private equity at CCMP Capital.
Ray has a BBA-Finance from the University of Notre Dame and a JD/MBA from the University of Chicago.