The Magic of Compounding Interest

Albert Einstein is quoted as saying that compounding interest is “the most powerful force in the universe.”

L.A. entertainment billionaire David Geffen has just been the victim of compounding interest, according to the L.A. Times:

“Media mogul David Geffen [...] recently spent about $10 million on a 1,473-square-foot two-bedroom house [in Malibu]. [...] What makes the transaction interesting is that Geffen owned this same property once before. He bought it in 1996 for approximately $1.2 million and sold it two years later…”

David Geffen bought it in 1996 for $1.2 million, sold it, and bought it back 12 years later for $9.8 million (which amounts to a more than 800% markup over the original purchase price).

Seems like Geffen got taken, no? Well, the magic of compound interest suggests otherwise. See, that 800% gain over 12 years amounts to only a 19% annual property appreciation rate, and shrewd businessmen like Mr. Geffen can often increase their net worth at rates above that level. They have investment options such as private equity funds (which generally aren’t available to those worth less than 8 figures) which historically generate returns above 25%. Warren Buffet, the famed stock investor, has averaged gains above 25% over the last 30 years. If we assume Mr. Geffen was using appropriate instruments to increase his wealth at these rates, then perhaps his $1.2 million sale and $9.8 million repurchase make sense:

$1,200,000 * 1.25¹⁰ = $11,175,870
$11,175,870 – $9,800,000 = $1,375,870.

Mr. Geffen’s gains from investments at an assumed 25%/year on $1.2 million dollars from 1998 to 2008 would turn his principal into $11,175,870 pre-tax. Buying the home back in 2008 for $9.8 million means that he would pocket an additional $1,375,870 (his investment gains minus the 2008 purchase price), would have avoided paying waterfront property taxes for 12 years, and still own the home. The only thing that he would’ve missed out on is use of the home for those 12 years, which wouldn’t hurt Mr. Geffen at all because he already owns a multi-lot palace nearby. This calculation is extremely conservative – Geffen probably pocketed much more than this projected $1.375 million because he probably sold the home in 1998 for more than the $1.2 million that he paid.

Assuming a 10% appreciation rate on the beach house in 1996 and 1997, Geffen would’ve sold the home for $1,452,000 in 1998, increasing his investment principal by $252,000, and his total to $13,522,000 in 2008, leaving him an additional $3,722,000 instead of the $1,375,870 we calculated earlier without adjusting for real-estate appreciation.

Perhaps Mr. Geffen didn’t let compound interest beat him, and instead, he taught the power of interest a lesson.

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