When contemplating vehicles of wealth creation, you are presented with a multitude of options, from active endeavors to completely passive investments. What works for one person may not work for others; their risk tolerance could be different and so could their goals. Some people want to be in total control of their investments and others want to be completely hands off. Most people land somewhere in the middle. Some are willing to risk a large percent of their net worth on an investment that could lose its value and others want a secure and reliable return. Some rely on the cash flow or dividends of the investment while others rely only on the value of the asset at the end of their hold period.
Common options for investing are stocks, bonds, real estate, and commodities. Another popular option in the US is entrepreneurship or owning your own business. Each of these vehicles has its own level of risk and its own level of reward as well as its own level of work on the investors part. We believe that the best investors are the most educated investors but that isn't for everybody, some people want to park their money in a mutual fund and not look at it, hoping market forces will increase their initial investment. When you compare the different asset classes on a chart you can see that real estate has a comparable level of risk to government bonds and average returns higher than small and large cap stocks.
Reasons we like real estate as our chosen method of investing
The net income after all expenses and debt service are paid is known as cash flow. This is one of the biggest benefits with real estate, you can earn monthly income on the properties you own. Over time rents tend to increase which will have a positive impact on your cash flow.
Tax breaks and deductions
There are numerous tax breaks available to real estate investors from the expenses paid on a property to depreciation. You can deduct the reasonable costs of owning, operating, and managing your investment property.
Depreciation is one of the biggest tax breaks you can receive as a real estate investor. The IRS not only wants you to depreciate your property, but they assume you do and will perform a depreciation recapture when you sell the property. Depreciation only applies to the improvements on the property and not the land. The simple way of depreciating the asset is to determine the structures value at purchase and divide that by 27.5, this is your yearly depreciation until the cost basis hits $0 at year 27.5. There are more complicated ways of depreciating an asset that involves an engineering study, so it is usually reserved for properties whose value is over $1,000,000. This is the cost segregation method and divides everything in the property into separate buckets of 5- 15- and 27.5-year depreciation schedules. For example, if you replace the carpet, under the old model you will depreciate the cost of the capex over 27.5 years, under cost segregation you could depreciate the same amount over 5 years.
You can even defer your capital gains taxes and depreciation recapture through a 1031 Exchange. This allows you to trade like kind property and delay paying the taxes on the sale of the property. You can continue doing this indefinitely each time you sell a property. There are extremely strict rules that you must follow while employing a 1031 Exchange, but it can save you great amounts in your tax liability.
There are two types of appreciation we focus on in real estate, natural and forced appreciation. Natural appreciation occurs because real estate in the US generally appreciates in value over time. As you own the property, next year it will be worth more than it was this year and a future sale will net a positive return. Of course, this is dependent on the market and sub-market where the property is located as well as the condition of the property. This combined with cash flow are two of the main ways real estate investors make their money. Between 1968 and 2009 housing had an average appreciation rate of 5.4%. Forced appreciation happens by a result of something you did to the property of the operation of the property to increase how much the property is worth. This is usually done by either increasing the income or decreasing the expenses.
Hedge against inflation
Owning real estate is a great way to protect the value of your money today from the inflation of tomorrow. Between 1968 and 2009 the average inflation rate was 4.6% per year. Because the appreciation rate is higher than the inflation rate you not only retail the value of your money but also increase its value over time.
Math warning: Inflation means that $100 today is going to be worth $95.40 next year. As previously stated the appreciation of housing averaged 5.4% over the same time period meaning housing had a net increase of 0.8% meaning that for every $100 of property value you have this year, next year it will be worth $100.80 next year in this year’s dollar value. This is equivalent to earning about a percent on the money you have invested but you are also collecting the cash flow and utilizing the tax savings. For comparison, since 2013 US savings accounts have averaged a 0.06% interest rate on deposits which means your deposit of $100 gained 6 cents to be show $100.06 at the end of the year. In 2013 the US was still climbing out of the Great Recession and inflation was kept to a low 1.5%. If you consider the inflation rate your $100 was worth $98.50 at the end of the year. Your $100 from the beginning of 2013 was worth just $98.56 at the end of the year which means you had a loss of about 1.44% of the value of your investment.
As your tenants pay you rent you pay your mortgage down over time meaning you have more equity in the property. You can use that equity in the future to purchase more properties. Three common ways to do this are selling the property, utilizing the 1031 Exchange, and doing a cash out refinance into a new loan.
A cash out refinance will increase the principle balance and the term of the loan but a cash out refinance is a non-taxable event. Also, because commercial property is valued based on its income and lenders borrow off the value, you should still have a positive cash flow after the refinance.
More math: Assume you purchased a property for $1,000,000 and had a loan for $800,000 over time you paid the principle down to $700,000 but you have also increased the value of the property to $1,250,000 through a combination of forced and natural appreciation. There are banks that will allow you to take out a new loan for 80% of the new value ($1,250,000 x 80% = $1,000,000) of the property and allow you to have the difference ($1,000,000 - $700,000 = $300,000). This new $300,000 is yours as a tax-free event and you can use it to purchase your next investment property.
Leverage is borrowing money to buy property, commonly known as a mortgage. You can partner with a lender to borrow capital to purchase real estate, usually up to 80%-85% of the value of a property. The lender will require you to provide equity as your down payment, typically 15%-30% of the purchase price of the property. Because real estate is a tangible asset it can be used as collateral to purchase itself. To look at it another way, a bank will lend you a million dollars to purchase real estate, but they will not lend you anything to buy their own stock. This is a huge benefit of real estate investment.
To conclude, investing in real estate has a risk level on par with government bonds yet returns that exceed most stocks. Real estate also carries benefits such as cash flow, tax breaks, and leverage. For these reasons we tend to believe cash flowing rental properties are great additions to any investment portfolio and should be considered by anybody who wants to build wealth through their investments.