How to Make Money in Real Estate with the Velocity of Money
About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 15 years. He’s also the co-founder of SparkRental.com, an online resource which provides free landlord education and video series for anyone looking to build passive income from rentals.
If you could earn an 8% return on a property you can flip within three months, or a 12% return on a property that will take six months to flip, which one should you buy?
Here’s exactly how your velocity of money impacts your bottom line as a real estate investor.
What is velocity of money?
In macroeconomics, velocity of money refers to the speed at which local currency moves from one transaction to another. It’s used to measure how healthy and robust an economy is.
The same concept applies to real estate investing because investors can reuse the same investment capital to buy multiple properties. That is one of the advantages to flipping houses over other types of real estate investment strategies. A house flipper can use the same money to buy and renovate one property, sell it, then turn around and do it all over again with another property in a short period of time. In this way, the 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!
Although most new real estate investors focus almost exclusively on return on investment, learning how to make money in real estate is just as much about the speed of earning the returns.
How to make money in real estate using velocity of money
When buying a house to flip, new investors typically only look at costs versus profits. They add up all the expenses and then subtract those expenses 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 costs and profit are not the only metrics worth calculating when writing your business plan. You should also factor in how long the project will take to complete, using the scope of work as guidance.
In other words, instead of only looking at absolute return on investment, try also thinking in terms of monthly rate of return. Instead of just “I’ll earn an 8% ROI on this deal,” consider “I’ll earn an 1.5% monthly rate of return on this deal.”
Take a property that’s going through a full gut and renovation. It may need six months or longer just for the renovation stage of the project to be listed for sale. This is in addition to the period where the property is under contract to buy, as well as the marketing period.
Your investment capital in that deal could be tied up for nine or ten months, preventing you from acting on new opportunities, or responding to changes in the market.
Instead, imagine your house flipping business plan involves only cosmetic repairs. No permits or inspections from the local housing office are needed. Your team of contractors renovates the kitchen, bathrooms, flooring, amenities, and landscaping. Three weeks and numerous buckets of paint later, your property is listed for sale on the market.
Six weeks after that, you’ve sold that property at a profitable price and can put your initial investment, plus the profit from the previous investment money, towards work on the next deal much earlier than the full renovation example. This frees up your money to rinse and repeat at a much faster rate.
Here are a few examples to showcase varying velocities of money in real estate investments.
Example 1: High velocity of money in flipping houses
You have $20,000 to invest and are looking for ways to get started in real estate investing. As you explore how to make money in real estate, you decide to start by flipping houses.
For your first deal, you plan to start small, so you buy a property for $100,000 that needs $20,000 in cosmetic repairs and no large foundational renovations. A hard money lender funds the majority of the deal for you (more on leverage shortly).
From the moment you put the property under contract, your $20,000 investing capital becomes sunk in that project–it can’t be invested elsewhere. The clock starts ticking.
Because you use a hard money loan, you settle within two weeks, paying your $20,000 as a down payment. Over the next month, you make the repairs (financed by your hard money lender), then list the property for sale. Two weeks later, you sign a contract with a buyer. It takes another month to settle, at which time you walk away with $30,000: your original $20,000, plus a $10,000 profit.
All said, your money was tied up in the project for three months. You turned $20,000 into $30,000.
You could repeat that cycle four times in a year, reinvesting the same $20,000 to generate four separate paychecks of $10,000 apiece, for a $40,000 annual profit. That comes to a 200% cash-on-cash annual return ($40,000 annual profit/$20,000 investing capital)!
This is if you pocketed your profits after each individual deal instead of reinvesting them to buy more expensive and more potentially profitable properties. Thus, if you reinvest the returns, you could potentially compound your profits even further.
Example 2: Low velocity of money in flipping houses
Imagine instead that you buy a property requiring a full renovation and some foundation work. The numbers look attractive: you can still invest with only $20,000 as a down payment and working capital, and your potential profit is $20,000, rather than $10,000.
But instead of a month under renovation, the property ends up taking five months. Your investing capital ends up being caught in the property for a total of seven months, rather than three months.
In the first example, you earned a 50% cash-on-cash return over three months, or a monthly rate of return of 16.67% (50%/3 months = 16.67%/month).
In the second example, you earned a 100% cash-on-cash return over seven months: a monthly rate of return of 14.29% (100%/7 months = 14.29%/month).
Yes, your total return on the second property was higher in terms of sheer numbers. But it also took you more than twice as long, during which time your capital was tied up and could not be reinvested anywhere else. The monthly rate of return on the first deal was higher, even though the total return on investment was better in the second deal.
Example 3: REITs (no velocity of money)
Instead of flipping houses, say you settle on REITs as a real estate investing strategy. You park your $20,000 in a REIT, where it appreciates at 7% over the course of a year, and pays you 3% in dividends. You earn a 10% annual return, or a 0.83% monthly return.
If that sounds paltry in comparison to the flipping returns above, keep in mind that REITs are a completely passive investment. Hence, you invest very little time in buying your REIT shares. By aggressively reinvesting money in flipping houses and pursuing those enormous cash-on-cash returns, you invest more than money. You also invest hours, days, and weeks of your time.
Shares in a REIT are a long-term, set-it-and-forget-it investment. You don’t benefit from the velocity of money, but you also don’t have to put in repeated work.
The high returns on flipping houses are not “too good to be true”—they simply appear that way if you only look at the financial investment, and not the investment of time and labor.
How to make money in real estate with leverage
In the examples above, you invest only $20,000, yet earned hefty cash-on-cash returns. That’s because you’re leveraging other people’s money to put up most of the funding.
In the first example, you buy a property for $100,000 that needs $20,000 in repairs. If you buy and renovate it in cash, you tie up $120,000 of investing capital, rather than $20,000. This reduces your velocity of money to a sixth of its potential.
Why? Because if you had $120,000 to invest, you could potentially do six similar deals simultaneously, investing $20,000 apiece and borrowing the rest using hard money loans.
Even if you would have saved $5,000 in lender interest and fees by buying in cash, that still leaves you with a single profit of $15,000 after three months, for your $120,000 cash investment. In contrast, you could have done six deals investing $20,000 apiece, for a $10,000 profit each.
That’s $60,000 in returns, rather than $15,000. That’s the power of leverage.
How velocity of money helps you reach financial freedom
I am an enormous believer in financial independence and early retirement (what enthusiasts refer to as “FIRE”). Real estate helps you reach this level of financial freedom faster, through accelerants such as leverage and velocity of money.
What other investment vehicles can offer you these cash-on-cash returns? Because you can leverage other people’s money, you can only invest a fraction of your own money into a deal.
You can buy hundreds of thousands,or even millions, of dollars in real estate over the course of a year, by reusing the same down payment capital, because you can keep reinvesting the same cash over and over.
These two accelerants exponentially increase the returns you can earn and the speed you can earn them which sets the stage for reaching FIRE and financial freedom far faster.
Speed matters. If you’ve ever flipped a house, you know that soft costs–such as the cost of carrying a hard money loan, taxes, insurance, and utilities–can add up quickly. The longer you own a property, the greater your expenses and the lower your returns.
But your soft costs aren’t the only reason that longer property ownership can mean lower returns. By accelerating your real estate investing and boosting your velocity of money, you can recycle the same investing capital repeatedly.
Put your money to work for you, but not just once. Hard money lenders like LendingHome provide ongoing, recurring funding for successive real estate deals, with no limits on the number of deals you can do in a given year. The faster your money turns over, the faster you can accumulate returns, and the faster you make money with real estate.