Real Estate 040: Why Invest In Real Estate?
/If you have stumbled upon my blog, I am assuming you are looking for ways to start saving money, increase your income, or find ways to create additional streams of passive income (cash flow). I love to read business, self-help books, and the more I read these books, blogs, and success stories, the more I realized that over 90% of these people built their wealth through real estate (the other 10% were a mix of entrepreneurs, celebrities, athletes, and employees who struck gold w/ start-up company stocks). For me, real estate is great not only because it is a tangible, hard asset, but it provides a basic human need - a roof over your head.
There are a couple additional reasons why I like real estate as investments (not your primary residence, which I will discuss this in another blog post):
1. Leverage
If you have read the book Rich Dad Poor Dad, by Robert Kiyosaki, you will be familiar with the term "other people's money" or OPM. This is a fundamental concept shared in Rich Dad Poor Dad where by using good debt, or OPM, you can significantly increase your return on investment (ROI). For example, most real estate conventional mortgages will allow you to put down as low as 5% cash (with good credit and income, of course) for the purchase of your home. That means 95% of the home is financed by the bank. Now, this is a very simple illustration, and there are many different things to consider when choosing the amount of downpayment (i.e. Private Mortgage Insurance (PMI), interest rate, mortgage payment, etc.). However, by using leverage, you are able to preserve your hard earned capital for other future investments.
Example:
Purchase Price: $500,000
Downpayment: 20% ($100,000)
LTV: 80% ($400,000)
You cannot pay $20 dollars for an apple stock worth $100 and have the bank finance $80 (Not speaking about futures, options, margins, which is a whole different ball game). In a place like California where I live, real estate prices for a single family residence is so high (average $450,000) that without proper leverage, it would take me 10+ years to save enough money to buy a piece of real estate, let alone buy multiple. By using other people's money intelligently and analyzing the risk-reward, you can slowly build a portfolio that is leveraged and bring in cash flow for you every month.
Note: Other people's money can be anything from: Bank Financing, Private Lenders, Hard Money Lenders, Friends and Family, Home Equity Line of Credit (HELOC), and more.
2. Diversification
You may have heard the term, don't put all your eggs in one basket. This would have been good advice to the Enron employees who put their life savings, retirement funds, and other monies into the Company Stock which eventually plummeted to zero in the wake of the greatest accounting scandal that has rocked Corporate America. Although this is an extreme example, I personally am not comfortable having my retirement funds solely in the stock market. Although we have seen large gains (20%+ for my mutual funds during 2017 alone), I also know that these are all time highs, and this rise can't go on forever. I have diversified within my retirement account mutual funds to have a mix of cash, equity, bonds, U.S./International, REITs, however, if done carefully, tangible real estate properties will also be a great hedge against inflation as well as a means of diversification. Not only can you diversify in the type of properties: Single Family, Multi Family, Apartments, Commercial Buildings, but also in different markets like the West, Midwest, South, and Eastern states in the U.S.
3. Appreciation
Living in California, I have seen the tremendous appreciation that properties in my backyard have undergone in a short period of time. I was exposed to real estate during my parent's purchase of their primary residence back in 2012. Single Family homes with a typical 3 bed 2 bath around 1200-1600 sq ft were around $300-$350K in a decent B class neighborhood with an average school - places where you wouldn't mind raising a family. Looking at recent comps on Zillow or Redfin, I was shocked to see that these same homes that I walked through during 2012 are now selling for 500K or more, which equates to an annual return of 8.5% or total return of a whopping 56.3%!!! (Let me know if you find a mutual fund you can use leverage AND get those kind of returns!).
Now granted, I like to refer to the post Great Recession as the "golden years" roughly 2010-2014 where you can pretty much throw a dart in the U.S. housing market and come out ahead with massive appreciation (some markets more than others - coastal vs. linear). However, I personally don't rely on "appreciation" when I am analyzing real estate properties because it is like gambling. During the height of the housing boom in 2004-2006, people were drunk with appreciation until it all came crashing down, as such, I focus more on cash flow. That is, money in my pocket every month after all expenses (mortgage, insurance, tax, maintenance, vacancy, and property management have been paid).
4. Cash Flow
This is actually my top reason of why I invest in real estate, but naturally found itself here after appreciation. As mentioned previously, appreciation is "icing on the cake", but not my main focus. My main focus is to ensure that the property that I am investing in creates positive cash flow after all expenses are paid, and if it appreciates over time (hopefully outpacing inflation), then great! On the flip side, if there is another housing price correction and prices go down 15-20%, I am not that concerned, because although my rent may go down, I would have created enough cushion to make sure that the property is cash flowing and making money until housing prices go back in 6-10 years, just like it did in 2008-2016. In addition, if an investor was to take into account monthly cash flow + appreciation of rental properties, the total return on investment would be significantly higher than the average return of a S&P 500 mutual fund during the same period.
Cash flow will vary depending on the purchase price, down payment, interest rate, rental income, and other expenses/reserves. You want to be conservative during your analysis as there will always be unforeseen expenses, and being overly optimistic will set you up for a big disappointment.
5. Depreciation (Tax Savings) and Loan Pay Down
By using IRS rules, you can significantly reduce your tax liability through your investment properties. It should not be a surprise to you that some of the wealthiest people make more money but pay less taxes that the average middle or lower class using these methods. If you have an investment property, you can deduct all mortgage interest, property taxes, insurance, maintenance, repairs, and other fees (flying out to the Midwest to check on your rental property? expense it!).
Depreciation is a powerful tool in which you can depreciate the value of your investment property over 27.5 years. Using the example above (Purchase Price: $500,000 - land value $100,000 = building $400,000), you can annually expense $14,545 each year. If you rental income was $3,000/month or $36,000/year, your taxable income would immediately be reduced by depreciation (We will later cover how depreciation will lower your tax basis, and how savvy investors use 1031 exchange to continually defer taxes and build wealth).
Loan Paydown is also another side benefit of owning rental properties. My strategy with real estate is buy and hold rentals. From running numbers and speaking with multiple investors, you will not be able to make money from real estate properties if you sell in less than 5 years simply because of transaction costs (i.e. agent commissions, escrow, title, etc.) unless you are buying 15-20% below market value, doing value add rehabs aiming for forced appreciation, or the market appreciates significantly during that period. With buy and hold rentals, if you do a careful analysis, you will make cash flow monthly, and benefit from the tenant paying down your mortgage debt every month that property is being leased. Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.
Good Luck!
