Boosting Real Estate Profits Using the Velocity of Money
Editor's Note: This post was originally published in December 2018 and has been completely revamped and updated for accuracy and comprehensiveness.
Hey there, fellow real estate enthusiasts! If you're looking to up your game as a savvy investor, then buckle up and get ready to learn about a crucial concept in the world of real estate investment—the velocity of money.
Now, before you start yawning and zoning out, we can assure you that this topic is pretty interesting and can greatly impact your returns. So, grab a cup of coffee (or your beverage of choice) and let's dive into the world of real estate investing and how understanding the velocity of money can take your investments to the next level!
What is the velocity of money?
In a nutshell, the velocity of money refers to the speed at which money moves from one transaction to another. And for real estate investors like you, this means that you can use the same investment capital to buy and renovate multiple properties, potentially generating a new positive return on each property.
For instance, let's say you're a fix-and-flip investor. You can use the same money to buy and renovate one property, sell it, and then use the profits to do it all over again with another property. This way, that same $10,000 can be reinvested repeatedly to buy and sell several properties in a given year, potentially generating a new positive return on each property!
Now, I know that most new real estate investors tend to focus solely on return on investment. But making money in real estate is not just about how much you make. It's also about how fast you can make it—that's where the velocity of money comes into play.
Understanding this concept allows you to use your investment capital more effectively and efficiently. You can also potentially generate even greater returns.
How to make money in real estate using velocity of money
When it comes to flipping a property, new investors often focus solely on costs and profits. They tally up all the expenses and then subtract them from the after repair value (ARV) of the property to come up with a profit. They compare the potential profit with their costs to determine their rate of return.
But wait, there's more! There are other metrics worth considering when it comes to writing your house-flipping business plan.
One of these metrics is the timeline for the project. Instead of only focusing on absolute return on investment, think in terms of the monthly rate of return. So, instead of just saying, "I’ll earn an 8% ROI on this deal," consider, "I’ll earn a 1.5% monthly rate of return on this deal."
Let's say you're taking on a property that requires a full gut and renovation. This type of project could take six months or longer just for the renovation stage, in addition to the time it takes to buy and market the property for sale. This means your investment capital could be tied up for nine or ten months, preventing you from acting on new opportunities or responding to changes in the market.
On the other hand, imagine your house flipping business plan involves only cosmetic repairs. No permits or inspections from the local housing office are required, and your team of contractors can renovate the kitchen, bathrooms, flooring, amenities, and landscaping in just a few weeks. Six weeks after listing the property for sale, you've sold it at a profitable price. You can reinvest your initial investment and profits towards your next deal much earlier than if you had taken on a full renovation project.
By factoring in the timeline for your project, you can make more informed decisions about your investments and potentially flip properties much faster. So, the next time you're planning a house flip, don't forget to think about the monthly rate of return, and remember that time is money!
Let's look at some examples
Let's dive right into it! Let's take a closer look at some examples to really understand the concept of the velocity of money in real estate investing.
Example 1: High velocity of money in flipping houses
Let's say you have $20,000 to invest in your first fix-and-flip project in this scenario. You find a property for $100,000 that only needs $20,000 in cosmetic repairs, and you secure a hard money loan to finance the majority of the deal.
From the moment you put the property under contract, your $20,000 investment capital is tied up in the project and cannot be invested elsewhere. However, because you were able to settle quickly with the hard money loan, the clock starts ticking on your investment.
Over the next month, you make the repairs (financed by your hard money lender), then list the property for sale. Within two weeks, you sign a contract with a buyer, and after another month to settle, you walk away with $30,000 - your original $20,000 investment plus a $10,000 profit.
In total, your money was tied up in the project for only three months. You turned $20,000 into $30,000, with a 200% cash-on-cash annual return ($40,000 annual profit/$20,000 investing capital) if you could repeat this cycle four times a year.
Of course, this assumes you pocketed your profits after each deal instead of reinvesting them to buy more expensive and potentially more profitable properties. If you were to reinvest your returns, you could potentially compound your profits even further.
This example highlights the importance of understanding the velocity of money in real estate investing and how you can use it to potentially generate higher returns by flipping properties at a faster rate.
Example 2: Low velocity of money in flipping houses
Now, let's consider a scenario where you buy a property requiring full renovation and foundation work. Although the potential profit is $20,000 instead of $10,000, the property takes longer to renovate, and your investing capital gets tied up for a more extended period. Even though you only need $20,000 as a down payment and working capital, you end up waiting for seven months before you can realize the profit, instead of three months, as in the previous example.
In the first example, you earned a 50% cash-on-cash return over three months, translating to a monthly rate of return of 16.67% (50%/3 months = 16.67%/month). However, in the second example, you earned a 100% cash-on-cash return over seven months, translating to a monthly rate of return of 14.29% (100%/7 months = 14.29%/month).
Even though the second property had a higher total return on investment, it took you more than twice as long, during which time your capital was tied up and could not be reinvested elsewhere. In comparison, the monthly rate of return on the first deal was higher despite the second deal's better overall return on investment.
Example 3: REITs (no velocity of money)
If flipping houses doesn't appeal to you, you might consider investing in Real Estate Investment Trusts (REITs) instead. With a REIT, you can park your $20,000 and enjoy the benefits of passive income. Let's say you invest in a REIT that appreciates by 7% over the course of a year and pays a dividend of 3%. You'd earn a 10% annual return, which translates to a 0.83% monthly return.
While this return may seem small compared to the high returns of flipping houses, keep in mind that investing in a REIT requires very little effort on your part. You simply purchase shares and let the investment appreciate over time. In contrast, flipping houses requires a significant investment of time and labor. The high cash-on-cash returns of flipping houses are not "too good to be true" - they simply reflect the effort and risk involved in the investment.
REITs may not offer the same velocity of money as flipping houses, but they are low-risk, passive investments that can provide a steady return over time. Ultimately, the best investment strategy for you will depend on your personal goals, risk tolerance, and available resources.
How to make money in real estate with leverage
As the examples above show, leveraging other people's money to fund your investments can lead to hefty cash-on-cash returns with only a small upfront investment.
For instance, if you have $20,000 to invest and use it as a down payment on a $100,000 property that needs $20,000 in repairs, you can potentially tie up $120,000 of your investing capital if you buy and renovate it in cash. This reduces the velocity of money to a sixth of its potential.
Instead, consider using hard money loans to borrow the remaining $80,000 to fund the purchase and renovation. This approach allows you to do six similar deals simultaneously, investing $20,000 apiece instead of putting all your investment capital into a single deal.
Even if you would have saved $5,000 in lender interest and fees by buying in cash, you'd still have a single profit of $15,000 after three months for your $120,000 cash investment. In contrast, by leveraging other people's money, you could have potentially done six deals, with each earning a profit of $10,000, for a total of $60,000 in returns.
That's the power of leverage, and it can be a useful tool for real estate investors looking to maximize their returns.
How velocity of money helps you reach financial freedom
Real estate investing is a game changer when it comes to reaching financial independence and retiring early (FIRE). You can leverage outside sources of capital, meaning you only need to invest a fraction of your own money into a deal. This could allow you to invest in hundreds of thousands or even millions of dollars worth of real estate over a year.
The best part? By reinvesting the same cash over and over, you can keep reusing the same down payment capital, which increases the velocity of money and exponentially increases the returns earned and the speed at which you can earn them.
Real estate investing offers unbeatable opportunities for cash-on-cash returns that you won't easily find in other investment vehicles. These accelerants make real estate investing a great option for anyone looking to quickly reach FIRE and financial freedom.
Final word
If you've ever tried flipping a house, then you know that time is money. Soft costs like carrying a hard money loan, taxes, insurance, and utilities can pile up fast. And the longer you hold onto a property, the more you'll spend and the less profit you'll make.
But hang on, there's another reason why longer property ownership might hurt your returns. If you want to get the most out of your real estate investing strategy, you need to speed things up and keep your money moving. By doing that, you can use the same investing capital over and over again.
So, instead of letting your money sit around doing nothing, think about putting it to work for you. And don't just do it once. Keep the momentum going! The faster you can flip a property and move on to the next one, the better your returns will be.
About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 20 years. He’s also the co-founder of SparkRental.com, an online resource that provides free landlord education and video series for anyone looking to build passive income from rentals.