Passive Investor Tips is a weekly series hosted by full-time passive investor and Best Ever Show host, Travis Watts. In each bite-sized episode, Travis breaks down passive investor topics, simplifying the philosophy and mindset while providing tactical, valuable information on how to be a passive investor.
In this episode, Travis explains how to compound your returns, drawing on his own personal experiences to illustrate this fundamental and impactful passive investing concept.
The Velocity of Capital Explained
Travis purchased a townhome in 2009 for $95K. Today, the property is worth $250K. He decided to calculate the IRR of the property, which came out to a little less than 8%. If Travis had kept the property, he could have seen a decent return.
However, Travis chose not to keep the property. Instead, he rented it out and made renovations. He ended up selling the property for $135K just a few years after purchasing it.
After selling the property, Travis invested his gains into a new value-add project. He applied the same strategy to the new property: rented it out, made renovations, and sold it within a few years. He took the gains from the second project and invested in a third value-add project. This strategy allowed him to reduce taxes while keeping his capital moving.
By repeating this process, Travis was able to turn the capital that he started with on day one into just under $1M. The IRR comes out to 18%, which is more than double the result he would have gotten if he had held onto his initial property. This strategy is known as the velocity of capital — keeping your money moving from investment to investment, turning over as rapidly as possible, and compounding your returns in the process.
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Travis Watts: Welcome back, Best Ever listeners, to another episode of Passive Investor Tips. I'm your host, Travis Watts. In today's episode what we're talking about is the velocity of capital, and how to compound your returns. Disclaimers - as always, I'm not telling you or anyone else what to do. This is not to be construed as financial advice. So you do you, you check with your advisors, you do your own due diligence.
And with that top of mind, I want to start with sharing a couple stories with you to articulate this point differently than I've done in the past, if you've heard me on other podcasts and episodes. So stay tuned till the end, I promise I'll make it worth your time. This is a very fundamental and impactful concept to fully understand as a passive investor.
So the first story is this - I bought a townhome in 2009. I paid 95,000 for it. This was still on kind of the downward trend of the great recession. And today, I just looked it up yesterday on Zillow, and their estimate is that it's worth about $250,000 today, in 2022. So you might think on the surface, or on paper, "What a great deal. You bought it for 95k, it's worth 250k. You would have more than doubled your money in 13 years." But here's the deal. I also hopped online to use a free IRR calculator; that's the internal rate of return. You can just google them and I'm sure you'll find a handful... And I plugged in that scenario as an investment, to figure out what the annualized return was. And it came in a little less than an 8% annualized return. So that's not bad, but I want to share with you what I did instead. Instead, I kept that property just a few years, I rented it out in the process of holding it, I renovated it, it was kind of a fixer upper, and I ended up selling it for $135,000 just a few years later.
I then took those gains that I had and I rolled them into a new value add-project. In other words, another piece of real estate that was kind of a fixer-upper, where I could implement a very similar plan. I held that property a year or two after fixing it up, renting it out in the process, and I ended up selling it. I took those proceeds and I put it into a third project, where I did the exact same business plan again; it was a value-add fixer-upper. I increased the value by making renovations, renting it out in the process for positive cash flow to help offset my expenses, and ended up selling. And so you can see, it's a rinse and repeat. Keep in mind, these were not necessarily flips, because I was renting them out in the process, I was holding them more than one year. Typically, a flip is gonna be anywhere between 30 to 90 days, we'll say, on average. And it's not tax-advantaged when you flip properties. You're gonna pay short-term capital gains, which are taxed at ordinary rates, which are upwards of 40% plus any applicable state tax.
So I was holding them more than a year, so that I had long-term capital gains, which are tax-advantaged. For most people, that comes in about 15%. For long-term capital gains it could be upwards of 20%. Always check with your CPA or tax advisor. I'm just letting you know, that was all part of the plan, and part of the strategy, to reduce taxes and to keep the velocity of capital moving.
So long story short, I turned that initial capital into a little bit less than $1 million. Also keep in mind, I did not add additional capital to the mix. This was money I started with on day one, and I just kept turning it and turning it and turning it, and it ended up just shy of a million dollars.
So when you plug that into the IRR calculator that I alluded to, that's more like an 18% IRR, more than double the results of had I just bought the first property and said "I'm in this for the long run. I'm gonna buy and hold and just cashflow this property out." And this, my friends, is called the velocity of capital. In layman's terms, it simply means keeping your money moving, from investment to investment, turning over as rapidly as possible, putting your money in, getting your money back, putting it in something else, and compounding your returns.
Alright, now I want to share with you a second story that relates to multifamily value-add syndications. So about five years ago - true story, by the way - I partnered with an operator that never projects to sell. They simply buy, renovate and they hold for long-term cashflow, tax advantages and all the rest. So for example purposes, just to make the math simple, I'm going to say a $100,000 investment, and going into that deal five years ago, the cashflow in year number one right out of the gate was 8% annualized. And today, in 2022, it's around 13% annualized. So again, on paper that sounds pretty good, right? It's hard to find 13% cashflow right now in today's economic environment. But here's something to consider, and that's that I've never received any type of equity upside in this particular deal. It's just been a long-term cashflow play. And again, I might be in this deal for five more years, 10 more years, 20 more years, 30 more years. It's anyone's guess; it's up to the operator, because I'm a limited partner in the deal, I don't have a say so in it.
So I want to take that deal and I want to compare and contrast to another value-add deal that I did around the same timeframe, different operator. What their business plan was is to buy a value-add, fixer-upper property, to hold for about five years, and then to sell. So they're not in it for the long haul, they're in it for money, in and money out, as soon as possible.
Break: [00:07:57.25] to [00:09:41.08]
Travis Watts: In this deal the cashflow out of the gate was pretty comparable, about 8% a year. This operator chose not to increase their distributions year to year. We ended up holding it four years. They sold it early, and we'll use the same example of a $100,000 investment - you would have had about an $80,000 gain upon the sale. So when you add in the cashflow and the equity, it was basically a double your money in four years scenario, if you want to think of it that way to make it easy.
So what I did upon sale is I took all the gains - and of course, yes, there were taxes that I ended up just paying out of pocket. I added some of my own cash back to the deal to make a nice even number; we'll call it 200,000 even. I turned 100k into 200k, less the taxes, plus added some additional capital. So I had 200k now to go out into the world and reinvest.
So I ended up doing two deals to diversify. I put 100k in another deal, and 100k in another deal. So now I had $200,000 of capital working for me, instead of the $100,000. The deals I ended up investing in with the 200k had a little bit less cash flow by percentage, so it was 7%, if I remember correctly, and it had a projected IRR or a total return when you factor in the equity on the back end plus the cash flow of about 15%, just for frame of reference.
So I want to take a quick minute here and pause and point out two critical things already in this scenario. Number one is that my cash flow has already substantially increased dollar for dollar. In other words, when I was in the deal, the deal where they underwrite for five years and sell, I was getting about an 8% annualized cash flow paid out on a $100,000 investment. So that's about $8,000 per year in distributions. Upon the sale, I've doubled the amount of equity that I had. And as I went into the two new deals with a 7% cashflow, I had $200,000 to work with. So now, if you run the math, $7000 per year per deal is now $14,000 in cash flow. I nearly doubled my cash flow.
The second thing I want to point out about this business plan is we had already maximized the potential equity upside in the deal. In other words, we bought the deal, we did the value-add plan, now we have market rents, we had high occupancy, we had high collections... There really wasn't much more that we could do to that property to continue increasing its value. We would have to be now dependent on the market and inflation, and just general rent bumps every year to have the value keep trickling up. So since we were maxed out, we chose to sell, and move on to another fresh value add that needed fixing up, so that we had the full potential of adding value and appreciation to new properties.
So now we'll talk a little bit in theory about these new deals, that I'm still in today, by the way... And if they end up hitting their projections, if the operator ends up executing their business plan properly at the 15 IRR, that means I'm gonna have approximately $150,000 in new equity at the end of the five-year hold. And of course, it's investing, there's always risk; anything could happen. I'm not implying that this will happen. I'm just saying if it did happen, then the math is pretty simple - 200,000 invested, 15 IRR, that means a 15% annualized return when you count the cash flow and the equity, that's $30,000 per year, you times it by five years, which is the entire hold period... That equals 150,000.
So at this point, if I decided to continue the rinse and repeat cycle and strategy, I would now be working with potentially $350,000. That would be the $200,000 I put into the deals, plus the $150,000 in new equity upon the sale five years down the road, equals $350,000. Not factoring in taxes, once again, as a disclaimer, but $350,000 invested into some new deals at a 7% annualized yield would be $24,500 per year.
So I know that's a lot of math, I know that's a lot of numbers. If you're listening here to this podcast on audio, that may be a bit confusing; feel free to re listen to it and pause where needed... But let's zoom out. Let's back up just a minute. What I want to do right now is I want to compare and contrast the first syndication deal I did with the operator that never intends to sell, compared to the operator that holds for about five years and then sells and moves on to new opportunities.
So the first deal, with the operator that doesn't sell, basically the way it's panned out is year one cashflow was 8%, and that was about five years ago. So today, as I mentioned, it's 13% annualized cash flow. Let's just assume, for example purposes, that that trend continues; that we're going to bump our cash flow up by 1% every single year. That means five years from today, in 2027, I would have approximately an 18% cash flow on an annualized basis. That particular deal is not utilizing the velocity of capital. I may end up receiving an 18% annualized cash flow return five years from now, which would be 18,000 per year.
But the second deal that I did with the operator that holds about five years sells and turns over the property - that is an example of utilizing velocity of capital. So a 7% annualized return on 350k in equity five years from now would be 24,500 per year, versus the 18,000 per year. So that's about a 36% increase in the cash flow, assuming of course that the business plan goes according to plan. And this is all made possible by the velocity of capital; keeping your money moving, reinvesting all the time.
Thank you so much as always for tuning in. I hope you've found value in this episode. I try my best to keep these episodes short, and to the point. If we haven't connected on social media, Instagram, Facebook, BiggerPockets. LinkedIn, let's do it. I'm happy to be a resource for you or anyone else. Feel free to share these episodes with anyone you think could find value in them. Like, subscribe, comment. Thanks for tuning in. Have a best ever week. See you on the next episode!
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