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Real estate investment property

The Case For Real Estate Investment Properties

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.

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 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 ;)

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  • overall this seems like a good episode. What is going through my mind is the very swift change in tune from passive indexing to buy and rent. it feels those that have been listening up to this point was sold a very different tune when you suddenly say “you will never get rich with index funds, at times its not the right time to put your money into index funds, you need to market time them, and then rental properties is the way to go. folks will be asking: is this it? have they finally stuck to their tune.

    some questions i have is:

    1) Does your 25% or 18% is a leverage return or a return on Asset.
    2) Does the 8% conservative estimate a Net Rental Income, Cash on Cash Return, or Net operating income, or gross income
    3) On your Zip Car example, isn’t there a counterparty or tenant risk always that we should be aware of. i think its not so simple. if that is the case no one will buy cars and would rent and do zip cars. then rent vs purchase equation might be a more level playing field.

    Properties to me is:

    1) if you want appreciation you need to do work and time the market because longer term its growth is 1-2%
    2) leverage. you can get a 20% IRR because of leverage. however, if no leverage it is still good, just not as crazy
    3) if you are in growth mode, you want to leverage, but you increase your risks of increasing rates, equity margin call. if you want safety you don’t leverage and you down pay all, but you are very safe. there is seldom a middle ground. this is active management
    4) taxation. USA is a place where tax situation can be complex. and it makes the playing field unequal. if there are no capital gains and dividend tax, or you need to use the right accounts or face higher tax expense, properties might yield less than the total stock market
    5) i am a REITs investor in singapore. i do not pay capital gains tax and dividend withholding tax on the REITs dividends. for USA folks, if its the same, REITs are like individual property rentals. but individual property rentals rewards the hardworking folks. REITs in the USA do not pay out all their cash flow hence a lower yield

    • @kyith:disqus ! Thank you for coming in here guns blazing and laying it all out. I’ve been marinating on this for a few days.

      First of all, it certainly isn’t a very swift change, I’ve been obsessively researching it for nearly the entire year and only just dove in. There was quite a lot of false starts as well as risks that I needed to wrap my brain around. At the end of the day I’m a disciple of process, I believe you can make anything successful if you wrap it in the right process. That’s what I’ve attempted to do with REI.

      For the record, we never mentioned timing the market or anything about this being a good/bad time to invest in the stock market. We’re pretty open about not being able to predict the future and our love for buy and hold. However, we would be doing everyone a disservice if we didn’t try to cover every angle in the most unbiased way possible. At the end of the day you need to make your own investing decisions.

      To your questions:
      1. My return is leveraged with a 20% downpayment. I am also very disciplined on buying meaningfully below market value to provide some buffer. My current in-flight property appraised by the bank for $185k on the “income approach to valuation” while my purchase price was $116k
      2. The point here wasn’t to give a specific cash on cash or gross example but to compare the tax advantages of various types of return. Returns being equal, REI investing will beat out the market due to those tax advantages.
      3. Yes, absolutely. Again, it was a very simple example mostly to illustrate the level of return brought on through leverage. If you profited 1/3rd of what we said gross return would be in our example you would still far and away out earn an equivalent non-leveraged business. Mind you, the non-leveraged business still has all of the exact same risks.

      On your additional points:
      1. No appreciation, fuck it. I’m not in it for appreciation and we should hopefully come out pretty clear on that in the episodes this month. In our approach/analysis cash flow is king, appreciation is nice but we don’t even factor it in. It’s icing on the cake.
      2. Agreed. I’d go so far as to say that you have less personal risk if the bank funds 80% of the property than if you went all in.
      3. Yes, people tend to deleverage as they get older. There is no active management, you automatically deleverage every month your tenant pays your mortgage. The question really is, once you get to say 60% equity do you refinance back to 20% to unlock extra investment capital. The only activity is in buying/selling and like stocks, we think you should buy and hold here.
      4. I did take a US centric tax approach, however Tax Free Wealth covers only things that apply internationally and he’s very mindful to discuss edge cases. I recommend you get the book and learn directly from the source here. I’m definitely not a tax guy.
      5. Yes, REITs have a strong return in general and removes a lot of risk. They are an excellent way to get real estate exposure without all the work. I own REITs myself.

      • Hi Andrew,

        Thanks for replying to me. I think the home owning market is such that there are properties that the big boys couldn’t purchase at one shot, or when they do purchase, it is not as luctrative any more.

        I got my maths wrong, your cash on cash is on your downpayment not on assets.

        For the part on active management, i am more referring to paying additional other than your amortization, but also that to find these really great deals there have to be a search costs.

        In your examples, it seems….. the search costs is low because these seem to be around. I think a lot of people are asking about this as well.

        Best Regards

        • Simply put, there are huge REITs that, based on their prospectus, need to cycle or even divest of properties every X years. The process is highly inefficient even while these properties have been professionally managed, renovated and are actively rented. We’re looking at that market for our deals.

          • thanks for explaining Andrew

  • Nick

    Congrats on a kick ass summer Andrew! Really looking forward to the episodes coming out this month. I too am curious about diving into rentals. It’s a very different beast compared to simple stock market investing so the more info the better.

    • Thanks @disqus_5WRwsnthsr:disqus !

      You don’t even know, we went hard core this month. I’ve been going pretty hard core on the episodes, cutting deals and building a tool since July. I hope to blow your mind-balls.

      Do you have any specific questions or concerns about rental properties?

      • Nick

        Geez, where to even begin? Perhaps you’re covering it in your upcoming episodes but my main 3 are…

        1. Where to you even find these properties? (Like who would even think to look in XXX state/zipcode. In all 50 states, what got you to look at the state you chose?)
        2. How do you know there is even a demand for renters in that area? (I have a fear of buying a turnkey property in a ghost town and now I’m stuck!)
        3. How do you even go about finding a property management company in said area that you found your killer deal?

        I’m sure there is more but those are probably the main 3 that would cause me analysis paralysis and keep me up at night.

        • 1. The third episode of the month will share this part of the puzzle. If you’re an email subscriber you’ll find out ahead of time and get a jump on the competition. When you see it, the answers to your subquestions will become apparent here.

          2. That’s what the vacancy rate describes. What percentage of inventory at any given point in time is vacant. You can look back pretty far in history at this so it’s not a real surprise. If you don’t own the shitty part of that area’s inventory you’ll be fine. The worst vacancy rate’s I’ve seen in really really hard hit areas is about 10% which means the other 90% of rentals are occupied. We don’t even look near these areas, the places we talk about are in the 5%-7% range.

          3. What if the company was pre-vetted for you with a transparent set of guidelines and this company that vetted the company for you was a bulldog on your behalf to keep them in line? They’ll even opt to talk to them for you for free so you don’t have to worry.

        • jb1907

          I would never be an out of town landlord. You can’t visit the properties and they can/will get trashed. Even with a property manager, the stuff happens. PMs aren’t there 24/7. Tenants skip out before much can be done.

          • That’s why you screen potential tenants and take a security deposit. Even if you live in the area, what are you going to do? Sneak into the house while they live there or peek through the window? Business in general is not for the pessimist.

          • jb1907

            Screening only does so much. We had tenants that skipped and left their dogs at the house and the dogs tore up the siding. How is that screened from a credit report? At least if you are local, you can stipulate that you have the right to inspection with a 24 hour notice. If they are trashing the house, they can’t fix it all in 24 hours. It at least gives them the notion that you COULD drop by anytime vs being 3,000 miles away. The only reason we keep our two houses in Texarkana is the MIL works at the real estate company where the Property Managers are. They are pretty good at not revealing information in a timely manner. I have to constantly ask why the rent isn’t deposited by the 6th of the month and found out last month the tenants skipped. yes, we kept the deposit, but if the property now goes a month or two without another tenant, that kills your ROI, You now have to go thoroughly clean the house again and then hope you get new tenants soon.

  • Mushfiq

    Just a correction. You cannot depreciate the full property value. Property values are separated into two values: building and land. You can only depreciate the building value since that is what actual depreciates over time. Land does not depreciate.

    The rule of thumb is ~80% is the building value. If you want a more accurate number, you will receive a tax document from the county. It will state the assessed value of the land and building. You can depreciate the building value on there.

    As a side note, the podcast makes it seem property investments are easy. I want to make sure all newcomers understand – it is not easy! Do proper research. Take your time an learn. Go to REI meetings locally. Understand your market.

  • Steve Parker

    That was a bit of a hot mess, honestly.

    I find it funny how you guys mentioned how you’re going to work forever doing what you love, make lots of money…….Good for you, but don’t forget that things change. Cancer, kids, job loss, I be lots of people thought the same thing as you, and then life happens.

    I’ll be interested to listen to the rest of the series to see how this topic pans out.

    • Steve, why was it a hot mess? I certainly hope the rest of the episodes are useful to you. I’d gladly accept any suggestions.

      As for your comment on the “working forever” piece, I’m not sure you understand the nature of my work. When I’m on vacation, everything grows and runs without me. I on average put less than 20 hours a work a week into LMM – a very minor commitment. I would find it hard to believe that the income of this and my rental properties wont slowly increase over time.

      I also love working on it and talking with the Community so I hardly see it as work. I’d do it anyways.

      • Steve Parker

        I guess to me it seemed like you bounced around a lot. Lets look at this example, no change that example, no zip car, no meteor disaster, what about Thomas and his car loan? I see that it was an introduction, and you didn’t want to get too deep into one point. Just felt like you jumped around a lot. I don’t see myself investing in rental properties directly, but I look forward to seeing what you do with the topic. I am glad you mentioned risk, because a lot of people tend to forget about that.

        The work thing, IDK, Hard to explain, just be grateful that you can make money doing what you love. I think I just see your comments as a little smug and naive,and maybe I’m a little jealous. Still not sure how you convince people to pay to join the community, or how Thomas makes money on videos. I just can’t wrap my head around that.

        I like my job, but I don’t want to do it any longer than I have to. I’m 48, and at 62 or 65, or 67, whenever the math works I am going to stop doing this. Now at that point, I hope I can do other things I enjoy, either for money or as a volunteer, but it won’t be this job. Unfortunately, the things I enjoy are TV and Reddit.

        • think he meant that you guys cover different topics but seldom do a review to revisit some of these. i think listeners like to see some of these updates once in a while.

          • @kyith:disqus I agree and we’ll change that starting now. We’ll revisit some of this after the discussion settles down in October/December. We’re also working on another “focus month”, perhaps in November where we deep dive into another topic that needs some love.

        • We did bounce around a lot. I guess that’s how our minds work. I did quite a lot of prep and Laura often rescues us with her master editing skills. Part of the style is that it’s loose and conversational.

          I certainly hope I don’t come across as smug. At the end of the day I basically work two jobs. It might sound all easy and sexy but there have been many times where I’ve been a mess – four years in and failure still hurts just as much as day one. Every bad review is like a punch in the gut. In the beginning we did five episodes a week AND wrote articles/show notes AND built relationships AND answered hundreds of emails/tweets/fb messages. It was not easy. I’m flattered you might be jealous but there’s no question it’s been tough. Laura will be the first to tell you. My day job is easy street in comparison.

          That said, I love building and I know that as long as my fingers and brain work, I’ll be building. I also know that the nature of online business is that it grows passively on its own as people constantly discover it. Should I have to stop, the business wouldn’t.

          I love TV and video games, and I still do a lot of both. It really just comes down to siphoning off a hand full of hours a week consistently over a long period of time. Just, imagine if you took 5 spare hours a week and compounded it by 4 years – that’s over 1,000 hours. If you put 1,000 hours into something, you’d have an income stream as well.

          • Steve Parker

            Certainly didn’t mean that to be a bad review, I’m still listening,and I enjoy the show a bunch. I seem to pick up something from each show.

            For me, my spare time has been used up in a recent move, but after that, I am not sure what I would do as a side gig. Your podcast has caused me to think about that, but I’ve come up blank so far.

            Just downloaded the latest episode today, so I am looking forward to that.

            Keep up the good work.

  • Steve Parker

    The car example. You can’t ignore the other side of these examples. The company that buys the car still has the car, and it has value. Presumably, in year two they make the same income, but have zero capital cost. The company that leases the car has to pay again or they have no business. I understand what you were doing, but the true math is different if you account for everything.

    Just picking on you with this one, but it bugs me when people forget the other parts of the equation.

    • Steve, honestly, who wants the car? The guy who gets goosebumps for acquiring shit? It’s a fast depreciating asset. If you’re owning a car for yourself that’s another story but you know how I feel about that. Also, in 5-10 years only crazies will own cars, everything will be transportation as a service.

      You’re missing the point of the example. Yes, there are no capital costs in year two but you still spent a shit ton of money on an asset and in return have taken on 100% of the risk. Why do you think it’s safer to use a credit card over paying cash? It’s not your money and someone will fight for you.

      At the end of the day, investments are about your return. If you invest $20k in the stock market and make $20k, that’s a 100% return. If you invest $2k and make $20k that’s a 1,000% return. Now, if you can put a process in place that allows you to do that with the full $20k you’ll earn $200k. That’s the point.

      We’re not ignoring any part of the equation. If the car is the same in both examples the costs remain constant.

      • Steve Parker

        I wasn’t saying it was the best deal to buy the car, just that you can’t ignore that the company that buys an asset does have an asset, with a non zero value. I understand your point, that’s just a bad example of leverage since it is lease vs buy for a car. That’s not the same as finance vs pay cash for rental property, which is what you were talking about.

        • Dude, it’s exactly the same. Anything you buy losses value over time and, if you use it, gets wear and tear. If we’re talking emotionally than yes it is nice to own a car your kids can get use to or a home to raise them. Financially, it doesn’t make sense. Prove me wrong, share your math.

          • Steve Parker

            Dude, they are not the same.

            The topic was using leverage to buy a rental property vs paying cash. The property is hopefully an asset that increases in value. You own it and owe the bank. eventually, you still own it and don’t owe the bank

            The car example is a company leasing a car. The car will decrease in value, you don’t own it, and you owe the bank. Eventually you will not owe the bank, and you will not have the car.

            I can’t really show you the math, it’s a made up scenario. If they were the same, at the end of your property loan you’d have to give the house back to the lease company. I’m just saying it’s a bad comparison to make.

            Lease vs buy car for business finance vs pay cash for rental house.

            I am not arguing against using leverage when buying a house, I am not arguing for or against leasing a car for business.

  • DIY Money Guy

    Good job on this episode. My wife and I have had one rental property for a few years. It was actually the house she lived in before we got married. We are interested in getting more properties starting next year so good timing with this episode.

    A couple of thoughts while listening to the episode:
    1) It may be valuable to preface this episode a bit more how this is like a “stage 2 or stage 3” part of someones financial plan. You guys touched on it but would be helpful reinforcing that people need to first pay off high interest debt, saving up emergency fund, etc.
    2) Mortgage is likely the highest expense for most people. But not for those of us with young children. My largest monthly expense if childcare for my two daughters. I am paying about 2.5 times my monthly mortgage payment for childcare for my two daughters. Thank goodness it is only for a handful of years. So be ready for that just as a heads up.
    3) I’d be interested what additional resources you have found the most useful. You shared Tax-Free Wealth and some good links to the IRS tax code but big picture where did you get most of you “aha” moments in learning this info? Any other specific sites like Bigger Pockets or books in addition to tax free wealth?
    4) Why/how did you choose turnkey rentals vs. flipping properties vs. fixing up properties and making them rentals?

    • Thanks Drew! Hopefully by the time you’re ready I’ll have broken down how to tap the tax advantages left right and sideways so you can get the max out of your investments.

      1. I definitely agree. While I’ll admit we might not have touched upon it as much as we would have liked, very soon after these episodes we’ll be diving back into that general arena with some meat you haven’t heard from us. We’ve been pretty inspired lately ;)

      2. It seems I always get corrected in that children are massively expensive, never let you sleep and can be mighty intense. Way to scare a guy! I might be asking for your notes when we’re close.

      3. I’ll see if I can put something together for our budding REI page: https://www.listenmoneymatters.com/real-estate/. To be honest, it was a lot of reading, talking, watching, etc.. all over the place over many months and I didn’t really keep track. Every answer I got usually was quickly followed with another question.

      4. I chose turnkey rentals because “I ain’t got time for that shit”. I mean, I have time for turnkey rentals cause they’re easy, everything else requires time and I already have two jobs and a wife :)

  • jb1907

    The guy in the condo next to my mom died a few months ago. He was a heavy smoker. His brother has to deal with the estate. We are hoping to grab this condo from him for a steal. If it was in great shape, it would go for maybe $240K. If we can get it for $140K and put $40K in upgrades, we would put the MIL there so we have both Moms in one place. Then, when the time comes, we can blow out a few walls and make on giant condo. We would inherit both condos so even if we put in $200K for the renovation, we would still be ahead. Then we sell our house and travel the world and have a protected domicile while we travel. We could always rent them out if we choose. Or sell them both and find a condo with better amenities, but really, we don’t care about a nice pool or clubhouse. Tenants would be older with money so the risk seems low to turn both into rentals.