The Case For Real Estate Investment Properties
- Written by Laura Fiebert
Real estate investment properties can be a great player in your overall investment strategy and an excellent way to build wealth. It typically isn’t effected 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 so on todays episodes he will gives us a broad overview on why real estate can be great investment and what he has learned from his experience. We understand investing in real estate isn’t for everyone but it definitely is a 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 more risky 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 going 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 it 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 will 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 definitely 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.
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 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 actually 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, lets say you own a business and have a computer that is used for work purposes. When you purchase that computer with you 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 3 years. *This is just an example see the IRS website for actual tax code.*
It works the same for rental properties. A properties value can be depreciated over 27.5 years. You can deduct thousands from your tax bill every year just for owing 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. Lets say you have a 500k rental property and put 20% down. That means you have invested 100k into the property. The ROI, return on investment, is 7% (actually very low for real estate) which would get you 7k per year in gains.
Lets say you also have invest 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, 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 years because it simulates the economy. Thats why a large percent of the tax code is written to incentivize spending by offering tax deductions. You can be a lot wealthier by choosing to actively participate in ways the tax system rewards.
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. So, no matter how smart they are or how much they make a year at their 9-5 job, they are 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 money of others to create a passive income with little of your time. Real estate investment properties are a great way to use leverage. Like in the example above, using 400k of someone else’s money earned 7k a year plus a boat load of tax deductions.
Here is a quick example of rental car companies’ business model to show you the monetary 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 car 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 spent $1,500 a year they can by 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 peoples 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.
For most people biggest expense is housing, rent or mortgage. One of Andrews goals is to become mortgage neutral, make enough rental through real estate investment properties to cover the mortgage.
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 a 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 really easy to get hooked on buying real estate after you see the money coming in. Hell, we bought 3 properties in the last 6 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 are 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 of 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 be always be profitable.
Most importantly you need to adequately protect yourself. 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. We have some more episodes for you this month covering Understanding How to Evaluate Rental Properties, Picking a Property, Assembling the Team and Reducing Risk and a Chat with a Special Guest ;)