When peoples start to think about investing, real estate typically isn’t the first thing to come to mind. The fledgling investor hears a lot about the stock market, IRAs, 401(k)s and mutual funds.
All of those are certainly options and can have their place, but those who have been investing for some time, and particularly those who have an inside view of successful investment portfolios, will tell you that almost all who are considered “wealthy” have some or even a a significant portion of that wealth invested in real estate. Particularly, income producing real estate.
Investing in real estate provides a number of advantages that many other investment types just can’t match – making it a powerful wealth-building tool. Let’s look a little more closely at these advantages:
Advantages of Real Estate Investing
Real Estate is generally more stable over time than many other investments. The value of real estate will definitely fluctuate, but in a general sense, those values will not vary to the degree that you see in investments such as stocks or commodities.
Real estate benefits from an entire financial and loan industry built to allow you to use leverage. You’ll be using other people’s money (OPM) to accelerate your earnings and cashflow. It’s standard practice to borrow up to 80% of the cost of a real estate purchase. You can’t get that same leverage with stocks, bonds, commodities, futures and options.
Real Estate Investing allows you to scale in ways that other investments do not. Much of this is related to the OPM opportunities mentioned previously, and when coupled with capital appreciation, and the ability to use your other properties as collateral, you can build a portfolio and significantly scale up over time.
Real Estate Investing can be passive or active, short term or long term. You get to choose the approach that fits your needs. For example, you have the option of influencing the success of your investment more directly with active investing which we’ll cover further – and there are multiple ways to be successful. You can structure your investing approach to fit your aspirations, your available time, and your lifestyle.
While you can make a decision to invest based solely on capital appreciation and tax benefits, it’s even better to consider cashflow and income strategies that can ultimately bring you lasting financial freedom.
Cashflow is simply the difference in the amount of income you can get by renting/leasing a property minus the expenses to maintain the property. There can be many expenses such as financing costs like principal and interest, taxes and insurance; HOA fees, utilities, maintenance and repairs, and also savings in reserve for future capital improvements.
On the income side you will calculate amount of rental income you can get in the market, and factor in some level of vacancies that should be expected for any property. The difference between this income and the various expenses will result in the cashflow that you receive from your investment, typically on a monthly basis.
This can come in two different forms. The first is passive appreciation. You can’t directly control passive appreciation; it is the increase in equity you gain over time as the value of a property increases in the marketplace.
While real estate values can fluctuate and vary by market, over time, real estate values can often increase 6-7% annually offering protection against the effects of inflation. The second type of appreciation is more “active” in nature.
Active appreciation is the increase in value and equity your property obtains through efforts you make as the property owner. This is typically done through intelligently made renovations and rehab. These can be as simple as clean up and painting – or it may be from significant renovations up to a total gut and remodel.
You can also increase the value of the property by ensuring you optimize and increasing rents in line with changes in the market. The value of a rental property is ultimately determined by the rents it can generate, if you aren’t earning what the market will bear, your property is underperforming, and you are undervaluing your property in the marketplace.
Mortgage Balance Reduction/Equity Recapture
Over time, with each payment you make to your lender you are recapturing equity in your property. With income producing properties, this means your tenants are paying off your loan and increasing the equity you have in the property. The rate at which this occurs will be dependent on how you financed the property and the terms of that loan.
Since you are leveraging other people’s money (OPM) though, the more leverage you are utilizing, with a tenant covering these costs through rents, you are capturing equity that you can redeploy to other investments once the amount of equity is high enough to refinance or borrow against.
Real estate investments can result in a variety of tax benefits. Some of these include the ability to deduct mortgage interest and property taxes from income, favorable capital gains tax rates when holding properties for over a year, the ability to do a “1031 exchange” to trade an investment up into a different similar property deferring capital gains.
Most rental and income producing properties will lose money on paper, even if they are cash flowing, due to the ability to depreciate the “improvements” (you can’t depreciate land, only the building that resides on it) over a period of 27.5 years. This will mean you can offset other income with these paper losses.
This is essentially deferring taxes to a future date, something you can continue to do through tax strategies to rollover to other properties and continue to defer. You’re also able to write off expenses associated with maintaining and managing a property. There can be other as other tax benefits (always check with your accountant or CPA for tax advice).
And finally, real estate investing is a tangible asset that investors can see, touch, and control, giving a sense of security and control.
Although there are risks involved, such as market volatility and property management and the unpredictability of tenants, real estate investing can be one of the best methods for generating wealth over the long term for those who manage their investments wisely.
Now let’s examine the various types of real estate investing that you can consider.
Next> Active Investing