Everyone knows that real estate investing has been a favorite tool of the wealthy for protecting and growing their riches. Billionaire industrialist Andrew Carnegie once said, "Ninety percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.” But what is it that makes real estate so special? With the ongoing bull market in stocks and all of the constant media hype from Wall Street, why would someone choose to invest their hard earned dollars in real estate these days? A closer look at a solid real estate investment reveals some pretty amazing revelations that your stock broker may not want you to know. The common mindset around real estate investing is - buy a property in an upcoming market for $X, hold it for a bit, and then sell for $Y, profiting from the spread between Y and X that was created by appreciation in real estate prices. While this often happens and results in sizable profits, it turns out that there is much more going on behind the scenes of a good real estate investment. Here are five ways that apartment complex on Shady Lane can make you rich, along with a hypothetical (but realistic example of returns):
1) Cash Flow -- In simple terms your cash flow is the difference between the income from the property (rent) and it's expenses (mortgage, taxes, insurance, etc.). This is the actual cash that you put in your pocket every month.
2) Leveraged Appreciation -- Appreciation is the one that most people think about when it comes to real estate investing. This is simply the long term growth in the value of a property as market prices go up. The real benefit in real estate investing is that you can own the asset and benefit from 100% of the appreciation with only a small down payment. The bank loans you the rest, but they don't participate or benefit from any of the appreciation. I'll show how this really juices up your returns in the example below.
3) Amortization -- As long as you don't have an interest only loan, each month a portion of the loan payment goes toward pay down of the principal due. On an investment property, the tenants are technically paying down that loan with the portion of their rent payments being used to cover the mortgage. This means that each month, your equity in the property is increasing and the spread between the properties value and your loan payoff is growing (in a stable or growing market).
4) Tax Savings -- This one is a little trickier to put an exact measure on because everyone's tax situation varies, but in almost all cases, you will pay significantly less income tax on dollars earned through real estate than dollars earned from your W2 job. The US government encourages real estate investment through the tax code with benefits like; depreciation, expense deductions, and reduced capital gains taxes.
5) Hedge Against Inflation -- Inflation is actually a benefit to real estate investors with long term debt. As more dollars circulate, the pay down of your fixed mortgage becomes easier. Think of it this way; did a $50,000 loan seem like a really big deal 30 years ago? What about today? With long term fixed debt, the loan gets easier to pay back as inflation raises prices, wages, etc..
Here is a hypothetical (but realistic) example of how these five components add up to really increase your wealth. To make the numbers simple, we will use a single family home here, but imagine this same example on steroids in a 200 unit apartment complex!
You purchased an investment property for $100,000 using a $20,000 down payment, leaving a loan of $80,000 at 5% interest.
1) Cash Flow:
Rental income is $650 and expenses are $500 (mortgage, taxes, insurance, management, etc.) This leaves $150 per month or $1800/yr. Divide that by your $20,000 down payment to get a:
9% annual Cash on Cash return.
2) Leveraged Appreciation:
If the property appreciates in value by 5% (from $100,000 to $105,000), divide $5000 by your $20,000 down payment to get a:
Some quick math will bring us to the conclusion that with 5% interest on our $80,000 loan, we (our tenants actually) pay down $1176/yr in principal. Again, divide that by our $20,000 down payment and we get another:
4) Tax savings:
As I mentioned earlier, everyone will have a different tax situation but it is safe to assume that we will realize at least another:
The Federal Reserve is mandated to try to maintain 2% inflation over the long term so we will use that number to add an additional:
Wow!! Added together, we just got a 45% return on our investment! Of course, this is a simplified example and there will be unforeseen complications, additional expenses, and the occasional headache but even with some deductions from our 45% return, we're looking pretty good for a passive investment that we don't have to go to the office for 50 hours a week to earn.
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