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owning rental property

The Case For Owning Rental Property (Plus a Case Study)

Owning a rental property can be a great player in your overall investment strategy and an excellent way to build wealth.

It typically isn’t affected in the same way as the stock market so that it can provide diversification in your portfolio.

However, it’s important to understand the risks of the real estate market. Andrew just started investing in rental properties earlier this year soon today’s episodes he will give us a broad overview of why real estate can be a great investment and what he has learned from his experience.

We understand investing in real estate isn’t for everyone, but it is an awesome way to build wealth. We are going to tell you why.

Preserving Wealth vs. Building Wealth

Your money is getting decent returns in the stock market, so why invest in real estate market? It just seems riskier and a ton more work, right? Well, just like diversifying your investments in the stock market, it is also important to have diversification in your portfolio as a whole.

Investing in the stock market is great over the long term for reaching future goals like retirement. It preserves your money by providing small gains over many years protecting your money from inflation.

However, most of us will not get rich investing in the stock market alone. You can grow wealth but not go to make you wealthy. That’s where real estate investing comes in.

Owning real estate is like running a passive income business. It provides an excellent and for the most part reliable income stream. After putting in the initial work to find a great profitable property, 90% of the labor to maintain the property you can delegate out.

“Risk comes from not knowing what you’re doing.”  Warren Buffett

You can choose to be as hands off or as hands-on as you want throughout the whole process. There are companies that handle it all from soup to nuts. All you will need to provide is your John Hancock.

But, when you are looking to buy your first property you should try to be more hands on. Going through the whole process step by step will help educate you on how it all works, so you know what you are getting yourself into.

Depreciation

Before investing in his first property, Andrew read Tax-Free Wealth by Tom Wheelwright recommended by our guest Natali Morris. This opened his eyes to the crazy amount of tax benefits owning a rental property earn you.

Most people look at taxes as the government taking their hard-earned cash. However, Wheelwright says if you dig past the surface, the bulk of the tax code is there to provide incentives for stimulating the economy.

Only about 3% of the tax code is dedicated to how much you pay, but the other 97% is about how much you can deduct. 

For an easy example, let us say you own a business and have a computer that is used for work purposes. When you purchase that computer with your company money, you can deduct it as a business expense. But hold on a second, you can deduct more.

On average a computer will need to be updated every three years so the tax code might say you can depreciate the computer every year. How do you do that? You take the cost of your computer, divide it by three and deduct that amount from your taxes as a loss for three years. *This is just an example see the IRS website for actual tax code.*

It works the same for rental properties. You can depreciate an asset’s value over 27.5 years. You can deduct thousands from your tax bill every year just for owning a rental property making your rent income tax free.

Tax-Free Income

Ok, here is an example. Keep in mind, you can find a rental property for much less, but this was an easy example from Tax-Free Wealth. Let’s say you have a 500k rental property and put 20% down.

That means you have invested 100k in the property. The ROI, return on investment, is 7% (actually very little for real estate) which would get you 7k per year in gains.

Let us say you also have invested 100k in the stock market. It gives you an ROI of average 7% which is 7k a year as well. At the end of the year, you will have to pay capital gains tax on the 7K earned in the market to the tune of 15- 20%.

The 7k you made from the rental property would be essentially tax-free because you can deduct the entirety of your mortgage interest and depreciate the value of the property.

Using the property above as an example, you would be able to depreciate the full value of the property, 500k, even though you only invested 20%. So, for that 500K property you invested 100k into, the IRS will allow you to deduct about 15k in taxes each year.

Not only will the 7k in gains be tax-free, but it will also lower your other income by 8k. There are some other factors considered like land value when calculating these numbers. You can find the full example on the last pages of chapter one of Tax-Free Wealth.

Wait, that’s not all! You can also depreciate the cabinets, appliances and deduct any improvements to the property and the mortgage interest.

The government wants you to buy a new computer or property every some odd year because it stimulates the economy. That’s why a significant percentage of the tax code is written to incentivize spending by offering tax deductions. You can be a lot wealthier by choosing to participate in ways the tax system rewards actively.

The Power of Leverage

Simply put, leverage is using someone else’s money to make you money. Unfortunately, the majority of people don’t use leverage. They trade their time for money, earning a linear income instead of passive income.

No matter how smart they are or how much they make a year at their 9-5 job, they still have a limited amount of time which limits their earning potential.

“Leverage is the reason some people become rich, and others do not.” – Robert Kiyosaki

Leverage, on the other hand, allows you to use the money of others to create a passive income with little of your time. A rental property is an excellent way to use leverage. Like in the example above, using 400k of someone else’s money earned 7k a year plus a boatload of tax deductions.

Here is a quick example of rental car companies’ business model to show you the financial power of leverage.

Let’s say the Car Company #1 buys a Honda Civic for $18,640 cash. They rent the car at $12/hr for 40 hours per week earning them $480/week or $24,960 a year.

Contrasting, Car Company #2 used leverage to get the car and leased the same Honda Civic for $125/month or $1,500/year. They also rent the vehicle at $12/hr for 40 hours per week earning $480/week or $24,960 a year as well.

Company #1 would see 33% return on investment. Not bad
Company #2 would see 1,564% return on investment. Amazeballs.

You might be asking yourself – What’s the difference? They are making the same amount of money in the end. This is true, but because Car Company #2 spent only $1,500 a year they can buy more cars to earn then more money. They can by 12 cars to every one car Company #1 can because Company #2 is paying $18,640 per car.

When it comes to real estate investing, the ability to leverage other people’s money will accelerate your financial goals. Maybe 20 years ago home appreciation was the name of the game when it came to real estate, but today it’s all about the passive income. Get your cash flow on.

Understanding the risks

As glorious as real estate investing sounds there are of course risks. First off, it is an illiquid investment. It will likely take a few months to pull from the sale of the property. You don’t want to put all your cash into this sort of investment.

There is also the danger of over-leveraging yourself. It’s easy to get hooked on buying real estate after you see the money coming in. Hell, we bought three properties in the last six months. There is nothing wrong with that; you just need to do your math. And then do it again. You always want to be able to cover all costs even when things might not be going that great.

Knowing what the risks come with owning a rental property can make it easier to anticipate problems. If you’re considering becoming a landlord do your research and understand everything that can go wrong.

It won’t always be unicorns and rainbows – the roof can cave in, you may not be able to find a tenant or may have to pay for an eviction. These things most likely won’t happen, but you never know.

If you calculate your risks, research you properties thoroughly and plan for the worse case scenario you can always be profitable.

Most importantly you need to protect yourself adequately. You don’t want to get stuck in an ugly lawsuit because someone fell off your uneven front step. For first-time investors, the key to owning a successful real estate investment property is becoming educated about the real estate market in general.

To take a deeper look at the benefits and risks of owning rental property, here’s a case study with Pauline. Take it away Pauline!

From an early age, I was convinced owning rental property was the way to wealth, rather than investing in the markets.

I mean, you put 10% down, if that, tenants queue outside the place and beg for the privilege of paying off your property, and then you sell it ten years later for twice the price. That’s how it works, right?

I mean, you put 10% down, if that, tenants queue outside the place and beg for the privilege of paying off your property, and then you sell it ten years later for twice the price. That’s how it works, right?

Property One

At least that’s what I thought until I went to the bank and asked for a mortgage. Hearing them say “No” was the first slap on my college graduating face. I mean, I had the deposit, market rents were above the mortgage installments so the tenants would pay the whole thing, what was wrong with my banker’s risk assessment?

I had no job lined up after college and no other streams of income to repay them in case of vacancy was what. So I took my pride and my $25,000 and went to look for a cash property instead.

Lesson 1: Visit a potential property by day, by night, during the week and on weekends.

Even if it was a big chunk of my net worth, fourteen years ago, $25,000 didn’t buy you a lot. I found a 200sqft studio apartment in the worst neighborhood you could imagine. With my innocent eyes, I just saw a rough suburb, where the kids were probably a little bored, and smoke weed to pass the time.

In reality, the estate agent made visits in the morning, because at night gangs emerged, destroyed public infrastructure occasionally shot each other and made terror reign. Walk around the neighborhood to see it all. You never know what is around the block until you check for yourself.

Lesson 2: Don’t trust previous owners to be objective.

Ask for rent receipts, maintenance bills, etc. My tenant was an old man who had lived there for the past few years and was recommended by the previous owner. A few months later, he stopped paying rent. He would always catch up eventually but sometimes could go as long as three months without paying.

Lesson 3: While you’re at it, take landlord insurance.

Insurance would pay me while they’d chase his rent. I was living abroad and happy to pay for the convenience. Then my tenant died. His widow stayed in and didn’t pay another dime. The eviction process took about 18 months because a law prevented me from evicting in winter, and she was over 70 and had additional protection.

When I got the place back, it was in bad shape, and I had spent way more time than I had thought to worry about the property. I had been blinded by a low price and yields of 12% and failed to do my homework properly.

Lesson 4: There is a direct correlation between risk and returns 99% of the time.

12% is high risk. BUT, after eight years, the tenant/insurance had paid me back the property in rents. I sold it shortly after the eviction for $50,000. My $25,000 layout had yielded $50,000 ($25k in rents and $25k in profits) in eight years. A 22.5% interest rate. Suddenly my brain resets and I loved real estate again.

Property Two

To buy my second rental, I knew I needed a mortgage. I had saved another $25,000 but didn’t want to get a second studio. I still owned the disastrous one at the time. So I left sunny Barcelona and moved to the UK with one goal in mind: get a job to get paychecks to make the bank happy and get a mortgage.

18 months later, I was buying a three-bed apartment in a college town South of London. I took in a tenant and lived with my boyfriend. The three of us were paying off my mortgage, and my living in the property allowed me to keep an eye on everything. It was a new build anyway, so not much could go wrong.

Six months later, the boyfriend and I broke up, I gave my boss notice and left the corporate world, the country, and relocated to Morocco. I took in two more tenants to cover the bills and the property started cash flowing a little. It has been seven years, and the three tenants have long gone, replaced by other people I have never met. I am now living in Guatemala and manage the whole property from the distance.

Running the business doesn’t require as much work as you might think. To find tenants, I put an ad on a local ad board, with a long description and high-quality pictures of my place. It took me a while to redact it the first time someone left, but now it is just a matter of copy-pasting.

Then reply to tenant inquiries and make the first selection. I rarely accept couples, prefer young professionals to students, and always take people over 25. I’ve refined my filters based on previous experiences.

The people I select get in touch with the current roommates for an interview. By involving my tenants in the selection process, I am less likely to receive claims that they don’t get along. I’m happy with any candidate I send so I let them pick their favorite.

The person selected scans their passport and a signed contract I have redacted and wired me a month deposit and a month upfront. He/She coordinates a move in date with the tenants.

They pay a rent that is slightly below market, so I get less turnover. My three tenants have all been there for over three years which is unusual for a college town. I pay all the bills and build the cost of the rent. This way no one gets bitter splitting bills or seeing someone else spend too much time in the shower.

I keep them happy by being super responsive, fixing stuff the next day or refunding asap when they have emergency expenses related to the property. It is always cheaper than flying over!

In seven years, only one room has been vacant for one week. The positive cash flow repaid my $25,000 deposit a couple of years ago, and now I am still $500-ish positive every month. An amount I pooled to… yes, buy another property.

Property Three

High with my great UK experience, I thought everything would be perfect again when I moved to Guatemala. Tenant protection is strong there, and I was afraid of another never-ending eviction experience. So I decided to Airbnb the place and turned it into a guest house.

I only had $50,000 or so, so I went for a small fixer-upper and invested another $60,000 over the following couple of years, to make it better. The $110,000 property is worth around $150,000. I built in $40,000 worth of equity, which is another reason why I love real estate. But being Guatemala and all, I don’t get such a fabulous rental yield.

Full-time tenants would barely pay $500 a month. Airbnb generates about three times more, but it is not fantastic either. I plan on making the most money with appreciation over the next decade or so. But that means having my money stuck for ten years. Putting $150,000 into the markets at an average return of 8% would give me a fully passive income of $1,000 every month. I could live on that in Guatemala.

Instead, my guest house barely nets more, and requires me to work for the money! Supervising staff, fixing stuff guests break, answering inquiries, making sure people find the place. This was probably my worst hourly rate in any endeavor.

What keeps me going? I enjoy having people from all over the world visit my little corner, which I can pay two full-time staff and contribute to the local economy, and the perspective of that big paycheck down the road.

There are many ways to make money with real estate. Appreciation, leverage, cash flow, renovations – they’re just a few of them. But whatever it is, it requires work, or overhead to have someone do the work. You have to enjoy the stuff and be willing to put in the hours to research and upkeep your place. Otherwise, it is probably better to stick to index funds.

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