07/10/2020
The Four Pillars of Real Estate Investing
Real estate is far more versatile an asset than it seems on the surface. Your average person understands that buying a home is a wise move simply because its value is very likely to appreciate over time. While this may be true in many cases, it’s only one very small piece of the puzzle. In fact, there are four main pillars of wealth generation that make real estate such an appealing asset class.
Appreciation
Appreciation, or an increase in value over time, is very common in the world of stock investing. For this reason, many new investors can wrap their heads around this concept with relative ease. Most people understand that if you had purchased a home in a healthy real estate market 30 years ago, it would have doubled or even tripled in value today. Despite being the most well-known factor for profiting in real estate, appreciation should actually be regarded as the least reliable. If you’re counting on a home becoming more valuable simply by holding on to it to gain a profit, you probably aren’t making a sound investment.
People frequently point to the housing crisis of 2008 as an argument against the reliability of the real estate market to consistently appreciate. The housing crisis was certainly a devastating event that caused home prices to drop significantly. However, even if you had purchased a home at the peak of the market in 2007, the full value would have been recovered in less than a decade (based on median US home values).
Keep in mind, this was by far the most severe housing crash in history, and even in this case, value was recovered. When you factor in the other three wealth generating mechanisms, even the most risk averse investor will be put at ease.
Cash Flow
Real estate investing starts to get really exciting when you begin to achieve cash flow. Fundamentally, cash flow is a function of income and expenses. Of course, there are certain costs associated with operating an investment property. For example, you’ll be responsible for paying the mortgage, utilities, taxes, and insurance. In addition, you’ll need to take into consideration vacancy and the various capital expenditures you’ll need to budget for, such as the cost of repairing or replacing things like the water heater or roof.
On the other side of the coin, there is an obvious opportunity to generate income. As you may have guessed, the objective in a traditional rental is to collect rent from your tenant in an amount that is greater than your expenses. When this is the case, that extra income is pure profit, or cash flow.
This cash flow may only amount to a few hundred dollars each month. While it certainly doesn’t seem like a life-changing amount of money, it really does make a measurable impact when compounded over time. For example, if you had the option to take $10,000 today versus $200 a month for the rest of your life, which would you take? Some quick math would tell you that in 50 months, or just over 4 years you would have surpassed that $10,000 mark.
Taking this to the next level, let’s say you saved that $200 every month and put it towards purchasing another rental property. With each successive property purchased you are increasing the rate of cash flow and can move through this cycle at an accelerating rate. You could continue this strategy perpetually until you’ve achieved your desired amount of monthly income generated by your rental property portfolio.
Equity
What does it mean to have equity? Well, equity is essentially ownership. With most things, it’s likely that you either own it or you don’t. So why is it that when it comes to real estate, or many other assets, you hear equity expressed as a percentage? When you purchase a home with traditional financing, the bank is actually paying for the majority of the home. As the homeowner, you simply repay that loan over time, accruing equity as you go.
In the context of a rental property however, you are collecting rent from your tenants. So in a sense, it’s as if your tenants are actually paying your mortgage for you and building up that equity on your behalf. This is a powerful mechanism because it means that you can passively increase the value of your home that you yourself have access to.
Just to drive home the concept, let’s use an example with numbers. Let’s say you purchased a home for $1,000,000 with a down payment of 20% or $200,000. Your tenants pay their rent which, for the sake of simplicity, is equal to your total expenses. Even in the event that you’re not collecting any cash flow from this property and it doesn’t appreciate in value, by the end of your loan term you would still own a $1,000,000 property outright. In other words, you’ve gained $800,000 in equity simply due to your tenants paying off your loan.
Tax Savings
The final pillar of wealth generation in real estate is the huge number of tax benefits you gain by owning property. Whenever you start a conversation surrounding taxes, it’s important to clarify that you should never take tax advice from anyone other than a tax professional. This discussion will revolve around the potential benefits that many real estate investors have taken advantage of, but not all of them will neccesarily be available to everyone. The options available to you depend very heavily on your particular situation.
The bulk of your tax savings as a beginning investor will most likely come from depreciation. Over time, your home will undergo normal wear and tear that will decrease the value of the structure. Fortunately, you are able to deduct this expense on your taxes, potentially saving you thousands of dollars every year. The IRS dictates that you may deduct the total value of your home over 27.5 years. Be sure to note that this is the value of the home itself and not actually the entire purchase price of the property.
Another major contributor to your tax savings can come in the form of deductions that you have access to as a real estate investor. There are a large number of potential deductions you may have access to, including the more obvious expenses associated with maintaining your property, such as repairs or capital improvements. Some of the less obvious deductions include things like property taxes, insurance, and the interest portion of your mortgage payment.
Final Word
Real estate investing has been the primary strategy for creating wealth of more than 10% of the world's billionaires, and by now you can surely see why. Through the power of real estate you are enabled to have a multi-faceted approach to becoming wealthy, whatever that means to you. Today we’ve primarily covered the benefits enjoyed by investors using a simple long-term rental strategy. However, real estate has the flexibility to accommodate a huge variety of strategies that can be capable of furthering an investors efforts towards their goals. Armed with a little bit of knowledge and follow-through, you too can set out on your financial journey with all the tools you’ll need to succeed.
