Why Real Estate is the IDEAL Investment
There is an abundance of investment vehicles out there for one to choose from to invest their money – whether it’s stocks, mutual funds, gold, or Bitcoin. Many are used in conjunction to diversify and all have their pros and cons. It can be argued though that real estate is the IDEAL investment vehicle. I believe it is the IDEAL investment because it has five ways to make money and IDEAL is an acronym to represent each of those five revenue drivers.
In this article I will explain why real estate is the IDEAL investment vehicle for wealth building, retirement planning, generating extra cash or anything in between.
The Five revenue drivers in real estate are:
- Equity Growth
I’ll explain each below.
Investing in real estate is so attractive because it provides income every month. That income is the cash flow from each property and is accounted for after taking out all the expenses. It is the net number that goes into your pocket every month.
This cash flow is what can take you from working a job you hate to replacing that income with rental income. It is what attracts most
people to real estate investing. And for good reason! Getting payments sent directly to your bank account every month is awesome, believe me! You could be sitting on the beach or playing in the yard with your kids and still be making money. That idea blows me away and keeps me motivated to find new investment opportunities to generate more real estate income.
It looks like this:
You buy a house for $100,000. The rent is $1,200 a month. Your mortgage is $500 a month. All of your other expenses (taxes, insurance, vacancy, repairs and maintenance, and cap-X) amount to a total of $500 a month. Total expenses are $1,000 a month and the rent is $1,200 a month therefore you cash flow $200 a month. Assuming you put 20% down because this is a rental property, you put down $20,000 and make $2,400 every year. This represents a 12% cash on cash return (CoCROI). Not bad! Show me a stock investment where you can get $200 a month paid out to fuel your lifestyle with a 12% return on your money. I’ll wait…
The income from rental properties allows an investor to live off that income if they buy right and manage it properly.
One of the most fascinating tax benefits of real estate is deprecation. This is the often-overlooked aspect that does amazing things for your returns.
The IRS requires that owners depreciate their assets over 27.5 years on the residential side and commercial real estate gets a little more complicated with other methods and cost segregation where you can capture even more depreciation.
Depreciation is a tool that helps you keep more of what you earn and is unique to real estate investors. It reduces the investor’s amount of taxable income, so that less income is taxed. For as long as the depreciation schedule lasts, the investor can take advantage of less income being taxable and therefore keeping more for that duration. For example, if you made $10,000 dollars of real estate income in a given year, at a tax rate of 25% you would pay $2,500 in taxes to the IRS. If, however, you had $4,000 in depreciation expense for that year then only $6,000 would be taxable. At a tax rate of 25% that is a savings of $1,000 for the year. Now when you spread that out over more properties and a larger portfolio the savings can be massive!
It can come back to bite you as depreciation does get reapplied at the sale of the property. This incentivizes investors to hold on to their investment properties or sell them using another tax saving strategy like the all-powerful 1031 exchange – which when used correctly can defer taxes indefinitely if you sell using a 1031 exchange, roll the proceeds into another like-kind investment property, and pass to your heirs when you pass away (but that is a topic for another time).
As unbelievable as it sounds at first, the IRS gives incentives to real estate investors for owning real estate. Real estate investors provide housing for the population, which the government cannot efficiently do on a large scale itself. These incentives are almost like a way for the government to subsidize housing by including provisions in the tax code for real estate investors to benefit from playing by their rules. For specific advice, be sure to talk with a CPA and they can give you the best, up-to-date guidance on how to properly take advantage of real estate tax saving strategies. Depreciation is a powerful tool in the investors tool belt to save at tax time. And that is the challenge of gaining wealth; it is about what you keep not always what you earn.
This is one of my favorites because it’s one that a lot of people find hard to quantify but completely changes the game in real estate. Equity paydown as a revenue driver is caused when the mortgage is paid every month, paying down the principal balance of that mortgage. Each month, the difference of what the property is worth and what you owe on it grows larger and your equity builds. The mind-blowing part is that the tenants are the ones who make this happen! Each month they pay the rent, which in turn pays your mortgage. That is why it is one of my favorite revenue drivers – it happens just by the nature of your tenants paying rent each month, the basic reason why you would own property in the first place to collect the rent.
What’s more is that the longer you own the property, the more principle you pay down each month. Mortgage amortization schedules are created so that the front of the loan is interest heavy for the bank to get their return (if you recently bought a house, take a look at your mortgage statement and notice the unbalanced portion you are paying for interest each month). For those first few years it may seem like you aren’t growing much equity, but later on in the amortization schedule that shifts as you pay down more principal than interest and start building equity at a faster rate. These effects are compounded even further with larger loan balances because larger amounts of principal are getting paid down each month right from the beginning, so equity is built in chunks with the larger loans. And the tenants create that equity growth each month just by paying rent!
Appreciation is the factor that can generate extreme wealth whether it’s market appreciation or forced appreciation. One can be planned for and implemented while with the other you are at the whims of the market, which cannot be counted on. Let me explain the two in greater detail…
Forced Appreciation – This type of appreciation occurs when you add value to a property by rehabbing the property, or by increasing rents in the case of commercial properties. This is done by understanding the after repair value (ARV) or market rate of fixed up properties. If you find a property that is ugly, beat up, and smells weird you may be able to get a great deal on it and buy it well under market value. You would then fix it up and by doing so you bring it to the market value of other similarly situated fixed up properties. After you are done with the rehab, the appreciation that has occurred is the equity or rather the difference between what you bought the property for and what it is now worth as a result of those repairs.
For example, say you bought a single family home for $100k that with $50k worth of repairs you could make it worth $200k because other fixed up homes in the immediate area with similar characteristics of what you can rehab this home to have are selling for $200k. After the repairs, the home you bought for $100k is now worth $200k and you just forced the appreciation of the property by $100k. After your all-in cost of $50k, you net the difference of $50k as equity, or in other words, as net worth growth. This is forced appreciation at work.
In the multifamily space this is even more powerful because you can create massive swings in wealth because of how commercial properties are valued (multifamily with 5+ units are considered commercial). They are valued as a result of the income they produce and their value is determined by taking what is called the Net Operating Income (NOI), found by taking gross rents minus all operating expenses not including the mortgage, and dividing it by the capitalization rate (cap rate), which is determined by the market (what other similar properties are trading for) and a good way to think of it is the return you would get for property if you paid all cash.
If that got confusing, stick with me on this example:
Say you bought an 80-unit multifamily property. At the time of purchasing, the rents were $800/month and the NOI was $345,600. At an 8 cap this property is worth $4.32M. Let’s assume though that you got a good deal because the seller was motivated and it needed some work and so you bought it for $4M (good job). After putting $300k into rehabbing all the units and giving the exterior a facelift, you are able to increase rents at the property to $900/month and in course raise the NOI to $388,800. At an 8 cap you effectively increased the property’s value to $4.86M and created over $800k of value. This is real value that you can sell to capture, or refinance to put it to work on another property and repeat the process.
Market Appreciation – This one is much more straightforward. It is created by the market which in real estate goes up over time as sure as the sun rises in the east. This is caused by people being willing to pay more for the same house or unit over time. In most other investments, inflation hurts you. In real estate however, it works in your favor because your rents and value go up over time, oftentimes at a rate greater than inflation. This is why many refer to real estate as a hedge against inflation and why many of the ultra-rich dump their money into real estate investments – because it is a wealth preserver due to this fact.
In residential real estate, the value goes up because the market value is determined by what others are willing to pay for the same house across the same area. If you bought a 3 bed 2 bath home with 1600sqft and a garage a year ago for $200k and now 3 bed 2 bath homes with garages in your same neighborhood are selling for $220k, you gained $20k in appreciation. Many people stumble upon large gains from this fact alone.
In multifamily, market appreciation occurs when rents go up over time, driving the NOI higher. As we saw from the example above in the forced appreciation section, NOI is what determines value in commercial assets. When the NOI goes up, so does value. In commercial real estate you are buying an income stream so the more income that asset produces the more it is worth.
Market appreciation is to be taken with a grain of salt. I would suggest that 99% of the time not to buy based on appreciation alone. It cannot be counted on unless you are incorporating a value-add strategy and buying well under market. Counting on market appreciation alone is a good way to get caught with your pants down and be in for a world of hurt if your entire return was based on the assumption that the market will go up and then it does not go up. Like Warren Buffet said, a rising tide brings up all boats but when the tide goes down you find out who was swimming naked (aka exposed and not properly prepared). They key is to find cash flowing assets in good markets that are likely to appreciate. But let that appreciation be a bonus but do not count on it.
This revenue driver is one of my favorites in real estate. You may hear it called OPM for Other People’s Money or you may hear it called using the bank’s money. In either case, leveraging real estate refers to taking out a loan or mortgage for a percentage of the purchase price – usually capped between 70-80% of the value of the property. In this case you bring a down payment of 20-30% and the lien holder provides the rest.
Leverage can compound the other factors because you can buy into a real estate investment for less out of pocket than othe
r assets. You can go to the bank, whether for a single house or a large apartment complex and borrow 75% of the purchase price. Could you imagine going to Microsoft and asking them to front you 75% of the cost of their stock, and you put in only 25% to control the entire 100%? That would be insane. This is a major benefit to real estate investing. Instead of buying a $100k house you could put 25% down on four $100k houses to increase your cash flow and return!
The downside that is as you increase your leverage you increase your risk. Many people have lost their shirt due to overleveraging real estate. Look back at the 2009 timeframe when people were foreclosing left and right – this is because they were overleveraged and could no longer afford their mortgage payments. With any leverage, you want to make sure you maintain enough equity in the property to give you options should there be a downturn in the market and also ensure that you have cash reserves for each property you leverage. I recommend you have at least 6 months of reserves to weather any storm. You can avoid losing your shirt if you maintain a healthy amount of leverage, have cash reserves, and make sure the property cash flows.
Is Investing in Real Estate the Ideal Investment for You?
Investing in real estate certainly has its risks, like any investment. Don’t let anyone fool you into thinking that it is a risk-free asset class where values always go up over time. I would argue that they do go up over time but cycles in different markets may vary and have longer periods of stagnation or decline than others. And certain markets certainly do go down, like Detroit after the automotive bust. The learning curve can also be steep. However, there is opportunity to jump in and learn the ropes easily. Calculate your own risk level and what you want to achieve. I would venture to say that real estate has a strategy for any goals you may have.
Equipped with the knowledge of why real estate is the IDEAL investment – it produces monthly income, you can capture tax benefits with depreciation (among others), tenants pay your debt down over time and your equity builds, markets appreciate over time, and you can leverage for greater returns – you can create massive wealth with investing in real estate.