People save money from their earnings or other sources with the intent of spending it later in life or giving it to, or helping others.
To make it be available then, and to make it grow in the interim, they employ a forward looking time machine.
As with any resource you make available to others, you expect to be paid for providing it. Investments can provide a return in several ways. It depends on what you invest your money in.
We can organize them by the kind of return you get.
You earn money from letting other people use your money. Maybe a bank. They pay a fee for doing it. The fee depends on how much they must pay to get you to part with your money.
Savings accounts pay the least because you can take the money away any time you want. The bank would need to replace it if they had invested in longer term instruments. Banks will not use short term or demand money to invest long term. If someone has a 5-year term mortgage, you can bet the bank matched it with 5-year term deposits. Banks just want the spread between what they pay on deposits and what they can earn in the market. That spread pays their expenses and leaves a profit.
Someone could invest in mortgages or other forms of loans or bonds. They receive interest for letting other people use their money.
Investment spread is the return an investor receives above their cost to make the money available.
If you are willing to invest for a longer time, you can get a larger fee. Every investment has many resources the investor contributes. In the case of a longer term investment, the investor is giving up their money and they are giving up the right to get their money back until the end of the term. They should be paid for both things they invest.
If you are willing to invest with someone less sturdy than a bank, you take the risk of not getting the income promised and possibly not getting your capital back either. A person wanting money in a risky situation must pay more for it because now the investor is putting up money, time, and risk. The investor must be paid for each resource. That’s why a second mortgage, a mortgage that is secured behind another one, must pay a higher rate of interest or no one would invest in it. It’s riskier.
If you buy a residential rental property, say a three unit apartment building, you receive rent each month from your tenants. Unlike interest you don’t get to keep it all. You must pay for municipal taxes, insurance, heat, hydro, and maintenance of the property. From time to time a unit will be vacant or the tenant does not pay. You have no revenue from that unit but the expenses remain. Most landlords expect to use about 35% of the revenue to pay expenses. The ratio varies widely depending on the type of building, the number of units, how strong the legislation is that governs tenant landlord relations, and whether there are rent controls.
Once you have the “net rent” in hand, you address two more aspects.
Being a landlord for a small building is challenging work. Tenants are demanding and to save costs, you will do some of the maintenance yourself. In a large building, those problems tend to disappear but at the price of adding management charges to your expense load.
If you buy commercial property, the tenants pay more of the expenses. Some leases are “triple net” which means the tenants pay almost all the operating costs.
Commercial properties are easier to manage but harder to deal with if a tenant leaves. There are fewer businesses looking for space than there are people looking for a place to live.
Most people buy real estate at a multiple of the annual rent. The multiple for residential buildings is lower than for commercial because the expense load is so much greater. The idea is what is the cash flow the investor can keep and how does that relate to how much was invested. Sometimes called cash income on cash invested, or just “cash on cash” return.
The other principle way to invest is in the stock and bond markets
That is a big topic. More about that and how you can do it tomorrow and the next day.
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