Why Real Estate is the best investment for building wealth

Why Real Estate is the best investment for building wealth

*The following are opinions and should not be taken as advice. Always consult a legal or tax professional prior to making financial decisions.

When I first thought about buying a rental property, I had no idea what I was doing. I was familiar with exactly one rental market (where I was attending school). I wasn’t even really familiar with the housing market at all, just rental prices in the town. But I did know where students wanted to live (close to classes, bars and restaurants). And I did know how much they could/would pay, or better yet, what their parents would pay. With high rent prices and students living 8-to-a-house, the proposition of being a landlord seemed like all upside.

I was mostly right.

While I didn’t have all of the information when I dove head first into real estate investing, I learned quickly. Here are a few of the obvious, and not so obvious, advantages that real estate investing has to offer.

Cash Flow

In a business, income equals revenue minus expenses. Rental revenue is the money received from the rental of your property and can include rent, parking, and incidentals like pet fees, that come in throughout the year. Expenses can include the mortgage payment (both principal and interest), insurance, taxes, property management fees, maintenance, repairs, permits, etc. Cash flow is the revenue that is left over after all expenses have been paid. Cash flow alone can give you an unleveraged return (no mortgage or note) of ~5-10% on your initial investment or a leveraged return of ~10-15% or higher. This is the most obvious advantage of real estate investing.

Principal Paydown

If you decide to purchase a property using a mortgage or similar debt, you’ll make monthly payments for years until the balance is repaid. These payments will be part of the expenses used to calculate the cash flow above. However, since the payment consists of both a principal portion as well as the interest, paying your mortgage each month increases your equity in the property and should be counted as part of the return on your investment. Essentially, the principal portion of your monthly mortgage payment is like a deposit your renters make into a savings account which you get to cash out when you sell or refinance the property.

Leverage

Now we’re getting into some of the less obvious ways that real estate beats out other investments. Leverage is the benefit of using someone else’s money (usually a bank) to pay for a portion of the investment in exchange for regular interest payments on the borrowed money. For investment properties, you typically need to put at least 20-25% of your own money into the purchase and can get a loan for the rest. An example of the benefit of leverage is as follows: Let’s say you’re going to purchase a duplex that rents for a total of $20,000/year and the purchase price is $200,000. Yearly insurance, taxes, and other non-mortgage expenses we’ll say are ~$6,000. If you pay for the property in cash, your return will be 7% on your investment. If instead you get a 30-year mortgage at 5% and put 20% of the purchase price down, your monthly mortgage payment will be an additional $858.91 expense ($10,306.98 a year). But, since you only put $40,000 of your own cash into the purchase, your total return will be over 15%!!!

{$20,000 – $6,000(non-mortgage expenses) – $10,306(mortgage expenses) + $2,360.58(principal paydown) = $6,053.61 / $40,000 = 15.1%}

Appreciation

While most real estate investors don’t plan for appreciation in order to make their deals work, it is true that over a long time period, real estate prices tend to go up at roughly the rate of inflation (~3%). This can be a huge benefit when coupled with the use of leverage. Using the leveraged example above, if your $200,000 house increases in price by 3% in a year, it is now worth $206,000 and you have a paper gain of $6,000. Compared to the $40,000 in cash that you invested in the property, that’s a 15% gain due to JUST appreciation in ONE year.

Again, since we don’t usually count on appreciation and it’s just a paper gain until you sell the property, it’s really just icing on the cake. But that’s a lot of icing!

Tax Benefits

There are a ton of tax benefits and they change regularly. Fortunately, even when political administrations conduct sweeping tax overhauls, real estate tax benefits tend to remain. Here are a few of the current tax benefits which make real estate investing great.

Deductions

Pretty much any of the expenses that you pay throughout the year can be deducted from your rental income to decrease the amount of taxes you owe. Common deductible expenses include mortgage interest, property taxes, management expenses, permit fees, and many others.

Depreciation

One of the most used tax benefits for real estate investors is depreciation expense. This is a “paper” expense because it’s not based on any actual payment you made throughout the year. For residential real estate, you can depreciate the price of a building over a period of 27 ½ years. To continue with the above examples, we had revenue of $20,000 and expenses of $16,306 for a net gain of $3,694. However, since we can depreciate the price of the house over 27 ½ years (you can’t depreciate the land the house is on, so we’ll call the house’s value $150,000 for this example), we can deduct $5,454 each year. This means we will actually have a “paper loss.” Did we actually lose money? No, but that’s ok. And we can use that “loss” to offset any other gain we might’ve had!

Favorable tax rates

Real estate gains, like stock market gains, are taxed at the capital gains rate. If you hold either asset for longer than one year before selling it, it’s taxed at the long term capital gains rate. This is usually much lower than wage income is taxed and so making an extra, say, $5,000 from real estate is much better than earning an extra $5,000 would be from your W-2 day job.

1031 Exchange

But what if you want to sell your property to buy a bigger one? Won’t you get crushed on the taxes from the gains on appreciation? The answer is, you don’t have to. A 1031 exchange is a part of the tax code that allows you to defer the capital gains taxes when you sell a property and purchase another using the proceeds from the first, as long as you make the next property purchase within a year. This could essentially allow you to never pay the taxes if you continue to roll each sale into the next purchase using the 1031 exchange.

Inheritance

But eventually, you’re going to have to sell and when you do, you’re going to owe the tax man millions, right? Maybe not. If you never sell the property (or continue to use the 1031) and it is passed on in an inheritance, the tax code allows a “step-up in basis.” Let’s say you still own that $200,000 when you eventually pass away and it is inherited by your children. Except now it has gone up in value and is worth $1,000,000. Upon your beneficiary’s inheritance of the property, the paper value, or basis, of the house would increase to its current value and your children would only be responsible to pay future appreciation. How about that for favorable tax treatment!

Inflation

Inflation sounds like a bad thing, and it usually is. As time goes by, money becomes slightly less valuable and more of it is needed to purchase a similar basket of goods. When it comes to real estate, however, inflation can be a good thing. Remember that mortgage we got when we bought the house? The bank loaned us $160,000 and we agreed to pay them back $858.91 a month, every month, for 30 years. Due to inflation, the $858.91 we pay in year 30 won’t be worth as much as it was in year 1. In fact, if an average of 3% inflation occurs over that 30 years, the last payment will be worth about $353.61 in today’s dollars.

Not all of the benefits are financial, however. Let’s look at a few that are not.

Control

When you purchase a stock or mutual fund, your money is used at the whim of the CEO and/or the fund manager. When you invest in real estate, you are in control of your investment. You get to decide when to raise rents and by how much, if and when to make improvements, and who your tenants will be.

Simple

We all live somewhere. Whether you’re a homeowner or a renter, real estate investing is an easy concept that just makes sense. And there’s no crazy math. If you can add, subtract, multiply, and divide, you have the tools needed to invest in real estate.

Steady

Perhaps the most common investment vehicle people use is the stock market. Over the long run, the stock market has produced solid returns at a rate of about 10% a year before inflation. However, in order to average 10%, the stock market often takes investors on a wild ride. In a given year, a portfolio might gain 32% (2013) or lose 37% (2008).

Real estate investment on the other hand is much less volatile and can be much easier to diversify. The above percentages represent a well-diversified portfolio of the 500 largest US companies. With just a few properties, you can diversify away much of the risk of vacancies and large capital expenses. And since real estate markets are local, you could diversify much of the total market risk by investing across the country.

So what does this mean?

Well, many stock investors plan to live by the 4% safe withdrawal rule of thumb in order for their money to have a chance to last in retirement. Since real estate investments are less volatile, less money is required to have an equally good chance at that money lasting. In fact, you may not use a % rule of thumb at all. It probably makes more sense to think about your rental income replacing either your W-2 income or your expenses.

Conclusion

As you can tell, real estate investing offers many advantages over other investment vehicles. Using some or all of these advantages, you too can create the results you need to make a giant leap forward toward financial independence.

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