Like you and for me and I would safely say, most of the people on earth. We all have read and heard things that we thought we understood and had an understanding of and after a deeper dive we learned we didn’t really know as much as we thought.
The rule of 72 is one of those ideas for me.
Real Estate benefits significantly from something called compounding interest. Compounding interest is interest that is earned on the interest.
So what is interest? Money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt.
You have an interest payment on your car (hopefully you dont have a car payment) but if you do. The bank is charging you an interest rate on a annual basis on the money they lent you to buy that car. A house is the same way.
For the sake of this post we are only talking about compounding interest, because that is what the Rule of 72 is, but for your own knowledge there are four types of interest.
Fixed Interest: a good example of this could be a house or a car. The interest rate doesn’t change over a the amount of the time of the loan.
Variable Interest: Means it can change depending on market conditions, usually determined by an index.
Annual Percentage rate: As the definition states it is a based on a yearly percentage rate. So for a credit card, if you carry a balance it would be based on an annual percentage rate.
And lastly compounding interest: Which is when your interest starts earning interest and this is what happens with income producing real estate.
I said I would explain it in layman’s terms. But in case you are one of those readers who like the complicated stuff. Here is the equation for compounding interest.
Formula for Compound Interest
The formula for the future value (FV) of a current asset relies on the concept of compound interest. It takes into account the present value of an asset, the annual interest rate, the frequency of compounding (or the number of compounding periods) per year, and the total number of years. The generalized formula for compound interest is:
i=Annual interest rate
n=Number of compounding periods per time period
t=The time period
I told you it was a complicated.
But the rule of 72 keeps it simple. All you have to do is determine what your rate of interest is and divide it by 72 and it will tell you how long it will take that investment to double.
Now income producing real estate is difficult to calculate because there are so many variables impacting the rate of your return.
Things such as pay down of the debt, how much you can charge for rent, tax implications, hold period, etc.
However, you can determine on the front end of your investment one thing fairly simple. Whatever your downpayment is and what kind of return you can expect to receive on that and how long it will take to double.
Example: $50,000 down on a house. Let’s say you are getting a 10% return on that $50,000.
72/10 = 7.2 years.
So if you get a 10% return on your $50,000 each year for 7.2 years, your money would double.
As I said already. Income producing real estate has a lot of variables. Your returns on a yearly basis may equal 10% but after all of the other benefits, it is most likely a whole lot more.
Personal example: I bought two condos in 2014 and 2015. I paid $15,000 for one and $20,000 for the other.
For the last seven years these two condos have generated on average about $3,500 a year in cash flow. Again, this doesn’t count all of the tax advantages. This by itself is a 10% cash on cash return.
But I actually sold the properties earlier this year for 77K.
Time period: Roughly 7 years
Initial investment: $35,000
Sold for: $77,000
Double would be 70K but I received 77K.
So as you can see the rule of 72 applied here.
The rule of 72 is a simple analysis you can do when you are looking at an investment. Is it the only calculation? Heck no. But it is one you can use to quickly analyze a deal.
To your success and your future.