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Wealth building pyramid

March 15th, 2007 by Kenric

This pyramid was brought up by Tom Wheelwright during his presentation last weekend.  What this pyramid represents is the importance of the following components while investing.  I had never seen this before and found it very interesting.

At the top of the pyramid is compounding interest.  Compounding interest is a very slow method of investing.  Using 100% of your own money, you are making a return which as its rolled over year after year makes a decent return.  A $10,000 investment at 5% will become $14,000 in 7 years.  (40% return)

The next step is leverage.  In simple example of this is buying real estate.  If you took that $10,000 and were able to purchase a break even cashflow investment home at $50,000, and this home appreciated at 5% for 7 years, your home would be worth $70,000.  Of that $70,000, $30,000 of it is equity.  You have turned your $10,000 investment into $20,000. (100% return)

The next step is velocity.  After 3.5 years, your home would be worth $60,000.  You would have $20,000 in equity in this home.  What if you took out $10,000 of equity and purchased another $50,000 home?  After 7 years, you would own 2 homes worth a combined total of $130,000.  Your equity in these homes would be $40,000.  (300% return)

The most interesting part of this pyramid is taxes.  Taxes is sitting at the bottom of it.  Tom said that taxes is the most important part of investing and that it accounts for over 50% of your returns!  This was news to me and very hard to believe.

We know that real estate investing has some tax benefits.  This is going to be a very general example.  In our breakeven cashflow example above, we have writeoffs such as depreciation, home office, business expenses, etc…   So, in addition to the 5% appreciation increase, we are getting some tax savings.  If we just assume that you’d save $2,000 a year in taxes for each home.

To keep this simple, in year 5 you would have $10,000 due to tax savings.  You could again, go purchase another $50,000 house.  In year 7, this house is worth $55,000 and in year 6 and 7 you would have saved an additional $12,000 in taxes.  So now you have 3 houses worth $185,000 with $45,000 in equity and $12,000 in cash.  $57,000 from $10,000. (570% return)

Interesting concept huh?

My example was just using 20% leverage and slower velocity. To me, the eye opener was extra 170% return due to using your tax savings.  Remember, this was with an initial $10,000 investment in year 1.  If you invested $10,000 every year, where do you think the end number at year 7 would be?

Tom’s example had alot more zeros and alot more leverage and velocity which equated to much higher tax savings.  This is a very aggressive way to build wealth.  It’s definitely not for everyone but for people with high goals and aggressive dates, it shows that it can be done.

Posted in Personal Development | 3 Comments »
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