Benefits to Investing in Real Estate
Why real estate? Honestly, it’s all about the benefits! Real estate investing provides major wealth building benefits for those who choose to use it as an investment vehicle. These benefits include-
Benefits that stocks, bonds, CD’s, savings accounts and treasury bills cannot begin to compare to real estate. We will be discussing each major benefit in detail and you, the investor, can become wealthy over time because of these benefits.
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The first wealth building benefit we need to discuss is appreciation. Appreciation can be broken down into two classifications, market appreciation and forced appreciation. Market appreciation is appreciation gained from increased property values due to supply and demand for properties in the surrounding area. There is very little an investor can do to influence market appreciation. However, it is fairly easy to watch market trends throughout the United States and determine what markets are forecasted for appreciation based on determined economic data. Once those areas are known you can invest in those markets and gain tremendous appreciation. If you want to know how to capitalize on this tremendous opportunity we talk more about market cycles and trends in another section of the website.
The second type of appreciation is forced appreciation which is appreciation gained by increasing the property’s value through improvements made to the property. Examples of forced appreciation would include converting a carport to a garage, laying tile flooring in high traffic areas, adding a bedroom, bathroom, garage or bonus room. Forced appreciation is an excellent way to add value to a property quickly, but be careful as a lot of projects are “overdone” for the surrounding area and cannot be sold for enough money to recoup the investment in property improvements. Educating yourself about the area becomes important when you are forcing appreciation.
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Appreciation is a huge benefit for real estate investors, let us now discuss how appreciation and leverage relate in real estate. If you have a $150,000 home and property values appreciate 5%, you see a gain of $7,500 in just 12 months. Not bad, but not great. Let’s put this into perspective. First of all, most people don’t buy a $150,000 investment property using $150,000 cash, they use leverage. Most investors put down a small down payment and let the bank or mortgage company finance the balance. Let’s purchase the same $150,000 home but this time put down 10% or $15,000 as a down payment and have the mortgage company finance 90%. The appreciation stays at 5%. Does appreciation affect only your $15,000 down payment or does it apply to the entire $150,000 asset that you control? That’s right, the entire asset appreciates. A gain of $7,500 on a $15,000 investment is a 50% return on investment. That’s the power of appreciation and leverage in real estate!
Another important consideration is to realize the amount of money that you may invest in the property during the second year? Remember you have no down payment to put up as you own the property. And if the rent payments are covering the mortgage and related expenses, which it should, then you actually shouldn’t have any out of pocket expenses in year two. Assuming you broke even in year two on your monthly cash flow, meaning the rent covered all your expenses and mortgage payments, and the property increased just 5% again. You would now see an increase of $7,875 ($157,500 x 5%). You made another $7,875 but with no money out of your pocket. Your return on investment for year two can’t be calculated, it’s infinite because you put no money up but still received $7,875 as an actual return.
How does this compare to stocks or mutual funds? First of all, you can’t leverage stocks. No banker in their right mind will lend you a dime to buy stocks, it’s too risky for the bank. Not so with real estate, they will actually lend you up to 90% and sometimes even higher on investment properties. Since stocks can’t be leveraged, it’s a dollar for dollar purchase. If I want to buy $150,000 in stocks then I must pay $150,000. If the stock goes up 5% then I truly have only a 5% return because I cannot use the benefit of leverage. In our real estate example, I could get a 50% return because I only put up 10% of my own money and the banker was nice enough to put the rest up for me. With real estate since I put up only 10% or $15,000 I still have another $135,000 to buy other investments, whether that be stocks, bonds, or other real estate. You control the real estate asset with very little of your own money.
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Real estate offers another huge wealth building benefit that no other investment can match, depreciation. Depreciation is a tax benefit the government gives to real estate investors for investing, holding, and maintaining rental real estate. Depreciation is a paper loss that can be deducted from taxable income when no actual dollar loss occurs. The government reasoning behind depreciation is that over time the structure, if not maintained, would deteriorate and be of no useful value at some point in the future. Investors are offered this tax benefit to encourage investors to own and maintain rental real estate and provide housing for individuals and families who cannot afford to purchase a home. Rather than the government owning and maintaining rentals, which it could not do effectively in the past, it gives investors the tax incentive to do it on the government’s behalf.
An important fact when dealing with depreciation is that the land does not depreciate, only the structures on the land. Land can never deteriorate and will always have a useful value. Depreciation, as of this writing, is easily calculated because there is only one type of tax depreciation allowed on investment real estate, straight line depreciation. When dealing with residential rental real estate, the Internal Revenue Service (IRS) calculates depreciation by dividing the improvements on the property over 27.5 years. If investing in commercial real estate, depreciation is calculated by dividing the structures value by 39.5 years. Here is an example:
You purchase a single family home for $175,000 that you intend to rent. Most accounting practices allow 80% of the purchase price for structures and 20% for land which we will use in our example (the annual property tax statement is also a good source for determining the value percentage differences between land and improvements).
Purchase Price $175,000 Structure Value (80% of Purchase) $140,000 Structure Value / 27.5 Years $5,091 The annual depreciation is $5,091 per year for 27.5 years, a paper loss to your annual taxable income. If you had a net positive cash flow from this one rental property of $5,000 you could actually take that money tax free. The $5,000 in rental income would be offset by the $5,091 depreciation deduction. As a matter of fact, in our example the government would allow you to deduct the remaining $91 from your earned income from your job since you could not deduct all your profits from the rental income. How about that!
Now, I don’t recommend buying real estate only for the tax benefits but it is certainly a major benefit. You are not going to see tax free money very often so when you do you need to take it.
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This leads us into our fourth major wealth building benefit, cash flow. Cash flow is the amount of income derived from a property after all income and expenses are calculated. When calculating cash flow we are talking about actual dollars earned and spent. Depreciation is not included in cash flow calculations as it is a paper loss and not an actual dollar loss. If income exceeds expenses you have a net profit or positive cash flow. If expenses exceed income you have a net loss or negative cash flow.
Now your first thought may be that you want to make sure you always have a net positive income. For the most part you’re right, but not always. For example, one property we owned had a net loss of almost $250 per month. Ouch! However, we had a different exit strategy with this house. We were in a very strong appreciating market and the property was in a great location that was well anchored. Over the course of 18 months, the property appreciation exceeded $100,000! As you can see we weren’t too upset about the loss of $4,500 when we factored in appreciation. Sometimes it’s okay to have a net loss as long as you have a great reason and a solid exit strategy. If you don’t, stay away from negative cash flow like the plague because eventually, it will catch up with you. How do you think we know, experience can be costly at times?
What are we looking for in regard to cash flow? First of all, it is important to know that every investment has an upside and downside. The real questions to ask yourself are, what is the down side, can I live with it, and is the reward worth the risk? Having said that let’s look at each type of investment property.
Single family homes and condos are great investments. In most cases they appreciate more and faster than any other investment. They are also the most desirable asset in real estate. Everybody wants a nice place to live, and if everybody had their way, they would live in a condo or a home. The only reason people live in apartments is because they have to, not because they want to. Most families would prefer to live in a home, even if it means renting, than live in an apartment. Financing is fairly easy as well, and most banks will do a 90% Loan-to-Value (LTV) loan to anyone with good credit.
Here’s the problem - if your condo or home becomes vacant, you’re stuck paying all of the bills, i.e., mortgage, utilities, maintenance, etc. If you set aside some reserves, perhaps 3 months of expenses, this problem is resolved pretty quickly and is fairly easy to deal with. The other issue is that most investors want to manage the property themselves rather than letting a professional property manager handle it. If you are just starting out, this could be a great way to learn the ropes of the business which in turn will help you manage your manager a lot better. On the other hand, if you know what you’re doing, this is a big mistake. You’re time is better spent looking for another good deal and build your wealth through more assets than trying to save yourself a couple of hundred bucks.
The last problem with condos or single family homes is that there is not a lot of cash flow in the beginning years of ownership. Now if you have a solid plan, like our 10 Year 10 Point Plan to Retirement, then this can be solved quickly and easily. Or if you decide to hold on to the properties long term, have a fixed rate loan, your mortgage payment will stay the same but your rents will escalate over time. In just 5 years you may have a nice monthly income of $300 - $500 per home you own. Review our 10 Year 10 Point Plan to Retirement Book and we can show you how you can quickly payoff all your properties and retire with a lot of cash every month coming in.
Multi-family apartment properties are usually your best investment if you are looking for long term cash flow. The benefit with multi-family properties is that you have many tenants under one roof. Usually if one tenant vacates the premises you do not have to come out of pocket to pay expenses or the mortgage. For example, if we owned a 4-plex in which we were charging $600 a month per unit in rent, we would still receive $1,800 a month even if one unit was vacant. The other benefit to multi-family properties is that your purchase price is usually less per unit than on single family homes. For example, we may have a nice 3 bedroom, 2 bath home that we purchased for $150,000. One unit equates to $150,000 per unit. However, if we bought a 4-plex for $400,000 then we would only be paying $100,000 per unit, $50,000 per unit cheaper than the single family home which can make a big difference in your mortgage payment. In most cases your cash flows in multi-family apartments will always be positive if they are run professionally, even factoring in your turnover. In most cases, our goal is to have a net positive cash flow of $75 per unit per month on any apartment complexes we buy. That may not seem like a lot but if you have a 60 unit apartment complex that’s $4,500 a month coming in above and beyond expenses. And you’d probably be surprised at how easy it is to buy a 60 unit apartment complex, because the banking rules change substantially from residential lending to commercial lending.
As we mentioned before, with every investment there is always an upside and a downside and multi-family properties are no different. There are certainly some great benefits but there are also some pitfalls. One of those pitfalls and probably the biggest is that of tenant turnover. As we also mentioned earlier, almost every family would prefer to live in a home so you have a lot of people living in apartments who would rather not be there. Because of this fact, multi-family apartments attract a much more transient tenant. You may have college students living in your unit, or maybe a recently married couple who can’t afford a home just yet, or an individual who is recently divorced. Whatever the case, the tenant turnover tends to be high because of the tenant profile. In addition, repairs are typically higher. Once again you are dealing with a transient tenant so maintenance issues increase and costs to put the property back in rentable condition tends to be higher as well.
Another type of property is commercial. We are only going to touch upon commercial but if you would like more information, please feel free to contact our office or review our commercial tab section. Commercial properties tend to be excellent sources of cash flow for the long term. The tenants are businesses which tend to be stable, you can diversify business types substantially within your properties, and you lock tenants into long term leases. It is not uncommon for a tenant to have a 10-year lease.
Once again the downside is that it may take a lot longer to rent a vacant unit. Tenants may be looking for a specific location, a specific square footage, or a specific type of building. Prepare for vacancies that can last upwards of 12 months. In addition, if you do find a tenant they, may want changes to the property (to be completed at your expense) before they sign a long term lease. These improvements are known as Tenant Improvements (TI’s) and may cost the owner a substantial amount of money before the tenant moves into the location. Another downside is the cost of repairs can be considerable. A lot of commercial buildings are on a master heating and cooling system and if one goes out you might be spending $50,000 for repairs. Or you may have to re-roof a building, repair an elevator and put in a fire sprinkler system.
Commercial real estate can be wonderful for cash flow but I highly recommend you have deep pockets in the beginning as costs may overwhelm you.
- The last major benefit we want to talk about is principal pay down. This is such a significant benefit, much more than most people realize. In the beginning of this section we mentioned you can use leverage to purchase the property rather than using all your cash. The reason that we mention this is that you put up as little as possible and then let your tenants pay the property off for you. You can buy a $150,000 investment property and put up $15,000 as your down payment. Then over the years, your tenant’s money, not yours, pays that asset off. You bought a $150,000 asset for only $15,000. That’s the power of principal pay down. Do you see how, with a $150,000 in cash, you could buy 10 properties that are worth $150,000 each and buy those properties with only $15,000 down payment for each property? From that point on your tenants will pay off the loans that you took out totaling $1,350,000 and you will never have to put up another dime in your life. The benefits we’ve talked about are by far the biggest benefits to owning investment real estate. There are a lot more benefits that we have not yet covered like never paying taxes on the sale of your properties by utilizing a 1031 tax deferred exchange, never having to pay social security or Medicare taxes on your rental income, how you can take on a partner and split profits, depreciation, cash flows (however the two of you decide), passing the assets to your children tax fee, deducting a part of your vacation, controlling property without ownership and the list goes on and on. One final thought, stock brokers use an analogy frequently that they refer to as the 3-legged stool. They are referring to diversification and how you should be investing in stocks, bonds and cash. How far you venture into each category depends on your age, risk tolerance and other factors. We are here to tell you that a 4-legged chair is stronger than a 3-legged stool. And if you’re not investing in real estate you need to give that some serious thought. The two most common reasons people don’t invest in real estate are; their stock broker doesn’t relate information or sell them real estate (because they don’t make a commission on it), or they don’t know what to look for. We at The Real Estate Professors want to solve that problem. We believe you can invest in real estate easily and effectively thereby creating a 4-legged stool with the 4th asset class of real estate. It’s going to take some work on your part as you need to understand real estate. This is why we have put together such an extensive website - to educate you on the wonderful opportunities and benefits as well as the pitfalls. If we can educate you and take away your fear of real estate investing, we will have done our job. We also want to provide a quick and easy outlet for those investors who want to invest but don’t know where to go to find properties, all with a touch of a button.
