Why Real Estate is the IDEAL Investment | PREI 003
In this episode Marco discusses why real estate is the IDEAL investment.
Real estate is the most historically proven wealth creator.
In the episode we discuss what makes real estate the IDEAL investment. We break down the five major elements of real estate and discuss when the best time to be investing is.
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Why Real Estate is the IDEAL Investment
Welcome to Passive Real Estate Investing. I’m your host Marco Santarelli. This is the show where busy people like you learn how to build substantial passive income while creating wealth for the long term. If you’re new to the show, I encourage you to go back and listen to the first two episodes. I cover some foundational and introductory information there. If you’re joining us again, welcome back.
Why is real estate the ideal investment? Real estate has been the most historically proven wealth creator. More people, especially people in the middle class, have become millionaires and billionaires through real estate than any other investment in history. Back in 2012, Warren Buffett was interviewed on CNBC’s Squawk Box and he said, and I quote, “If I had a way of buying a couple hundred thousand single family homes, I would load up on them.”
This really got a lot of people’s attention, not just on Main Street but on Wall Street. In fact, since then, there have been a number of hedge funds that have come up with billions of dollars and invaded many markets across the country, starting with places like Phoenix moving east to Dallas, Houston, Atlanta. They just came in and they started buying up all they could possibly buy. They really didn’t care about the rates of return as much as the fact that they wanted buy at a “low price” and just build up a portfolio.
The problem with buying real estate at the institutional level and on such a grand scale is that it’s very difficult to do. This market, the real estate market, is a very fragmented market. It’s a fragmented industry. Every real estate market is local and every market has its own real estate agents and brokers. It has its own set of property managers and inspectors and whatnot.
It’s very difficult to manage this as an investment on a grand scale. But that’s really an advantage for us as a real estate investor. We can take advantage of these inefficiencies of scale, this fragmentation. It helps us as real estate investors because it allows us what used to be called mom and pop investing. It allows us to really build a large business out of it or a really large real estate portfolio for ourselves so we have that passive income through the cash flow.
Real estate is made up of many elements. It is not a simple one sided type of investment. Because of that, it makes real estate an ideal investment. Let me break that down. Why is it an ideal investment? Ideal is not just an adjective for real estate, it’s also an acronym. Each letter in the word ideal represents a major benefit or factor of real estate.
The I in ideal represents income. Income is probably the most important ingredient when it comes to real estate or any investment for that matter. Because if you don’t have cash flow from an investment, it really isn’t much of an investment in my book.
Not all investments provide income. If you were to go out and buy, let’s say, $100,000 or $10,000 worth of stock from the stock market, unless you bought a blue chip company stock that pays an annual or quarterly dividend, there really isn’t any cash flow, there is no income. That’s what differentiates real estate from stocks and many other investments, is that real estate has a regular monthly predictable income stream or generation cash flow that you can count on. That is a key benefit.
Now, let’s break income down into two aspects or two elements. You can look at it from the net operating income level or you could look at it at the bottom line level, which is the net cash flow. Let me explain.
Your net operating income is what you have when you take the gross income from the property, the rents, and you subtract your operating expenses, things like your property taxes, your insurance, your property management maintenance and repairs. What you have left over, let’s just call it $500, what you have left over is your net operating income.
Now, cash flow is what you have when you have a mortgage on the property and you have to subtract your debt service, the mortgage payment from the net operating income. What you have left is your net cash flow. This is spendable cash, you can save it, you can spend it, you could do what you will.
The beauty here is that after 30 years, if you have a 30 year mortgage or if you accelerate the payments, you’ll have a shorter pay off period. After that mortgage is fully paid off and you own that property free and clear, that net operating income becomes your passive income, your monthly passive income.
What may start off as $200 to $300 in positive net cash flow ultimately becomes larger because your mortgage is paid off and now your net operating income is your monthly passive income. Of course, year after year, your rents will go up a little bit, maybe every few years. Over time, that cash flow becomes larger and larger.
If you start off in year number one on your property with let’s say a positive cash flow of $200 to $300, in 10, 20, 30 years, that might ultimately become maybe $2,000, $3,000 because don’t forget, rents have gone up, you’ve paid off your mortgage or amortized it, and now you have your net operating income paying you every month of passive income. Think about what happens when you have two properties, five properties, ten properties. You could easily build yourself up at $10,000 or $20,000 monthly passive income through investment real estate.
The D in ideal is for depreciation. You see, this is where you can kick Uncle Sam where it counts. Because the IRS allows you to take a legal tax deduction on the depreciation of the property. You see, real estate actually appreciates over the long term. The improvements of that property, which is everything but the land, can be depreciated over a certain period of time.
This is what the IRS refers to as the useful life. You see, over 27 and a half years with residential property, that is one to four unit properties, and with commercial, that’s extended to 39 years. You can take that property and you can depreciate that property’s improvements over 27 and a half years, which is an amazing thing because depreciation is actually a non-cash expense. That means that you don’t have to spend a single dime in order to get that deduction. It’s an expense that you’re allowed to deduct and claim as a loss without having to spend actual cash.
Let’s just take a quick example. Let’s say, you have $120,000 property. The land value is worth $20,000. That lot is a $20,000 piece of dirt. The improvements, what’s built on that piece of land, is $100,000. Now, if you divide 100,000 by 27 and a half years, you get roughly $3,636. That is your annual depreciation that you can legally deduct from your income.
I have to clarify, I’m talking about passive income. This is a little bit more complicated for some people so the best thing to do is talk to your tax advisor to see how it actually applies to your situation. What I’m giving you is just a very simplistic example.
Let’s just say that property generates $2,400 a year in cash flow. That’s $200 a month times twelve months. That’s a very conservative calculation. You take $2,400 in cash flow, you subtract the $3,636 and you actually show a $1,236 loss. Even though you generated a positive cash flow and put money in your pocket from your income producing property, on paper, you’re showing, and for tax purposes, you’re showing a $1,236 loss.
This is what you might call “invisible profit” but it’s legal. This is allowed by the IRS on all residential property for 27 and a half years. Depending on your tax situation, you may be able to carry that loss over into other passive income. Again, check with your tax advisor to see how that works.
There’s one thing to be aware of here, the IRS is no dummy. At some point, they’ll want to say, “Hey, we allowed you to take that tax deduction, now we want it back.” This is what they call recapture. The IRS, at some point, will want to get that credit back, what they’ve extended to you in the form of a depreciation recapture.
However, there is a way around this and it’s known as a 1031 exchange. 1031 is the section in the tax code that allows you to benefit from this. If you were to sell that property and purchase other income producing properties. There’s a few rules that you have to follow. As long as you follow those rules, through a 1031 exchange, you can avoid or defer that recapture and never have to pay it. Robert Kiyosaki likes to call real estate the last great tax shelter.
The E in ideal is for equity. Real estate allows you to build up equity over time. There are two forms of equity that you can build into property. One is through mortgage payments. As you pay that mortgage off every month, you slowly amortize that loan and little at a time you build up more and more equity just through the repayment of that loan.
The other form of equity that you can build into property is sweat equity. If you were to purchase a distressed property or a property that is being sold by a distressed or motivated seller and you can get a good deal on it, meaning that it is significantly below the fair market value as if it was in good condition, you can build equity into that property. Sometimes people refer to this as forced equity.
With rental properties where you have passive monthly income, that tenant is indirectly paying off that mortgage. Every month, a little tiny piece, at least in the beginning, a little tiny piece of that monthly mortgage payment goes directly towards the principal of that mortgage. It’s like a forced savings plan if you will. Every month, that equity grows in the property a little at a time and accelerates over time, but you get more and more equity as that mortgage get paid down further and further.
Equity is what is on your personal balance sheet. It’s actually not in the form of cash flow. As that mortgage is being paid down every month, you don’t see your cash flow going up each month or every year. It has no direct effect on your monthly income from each property. What it does do is it increases your net worth and that is what you find on your balance sheet because your mortgage is slowly being eroded away.
Because equity is trapped in the property, you can’t get to it all the easily unless you have a home equity line of credit on the property. Not a lot of people do and if you do, that’s not necessarily the best way to tap into that equity because it’s just sitting there and it’s what I call dormant equity. It’s really not doing anything for you.
As the years go by and that equity increases, what you can do is you could refinance the property if you need to pull some or all of that equity out. The only reason you would want to pull equity out of a property is to use it towards other investments. It’s not there for you to go on a vacation or buy a new car.
What you want to do with that equity is reinvest it into more income producing property to continue to build your real estate portfolio, increase your cash flow to build up passive income for years down the road. Equity is really where the wealth is created in real estate. Some people don’t understand that.
They think it’s the appreciation that creates wealth well. No, the appreciation is icing on the cake. The equity buildup is what creates your bottom line in terms of your wealth. The equity happens in two forms. It comes through the amortization of the loan and it also happens through appreciation, which is the A in ideal.
Appreciation is really the yin and depreciation is the yang. They go hand and hand but together they’re very powerful. You can build wealth without appreciation. Appreciation is nice to have and if you invest properly, in other words, you’re in the right markets and of course you’re choosing the right neighborhoods, you will see appreciation. Over time, that appreciation should keep in lock step with the national average of inflation.
Depending on whose numbers you look at, if you’re looking at headline inflation numbers, you’re looking at typically around 2% to 3%. Historically, over the last 30 years, the national average for appreciation has been 4.6%. What you want real estate to do and what it has done historically if you go back long enough is it keeps up with the rate of inflation. That’s what it should do because real estate is really nothing than a bunch of commodities slapped together on top of dirt.
Appreciation is the icing on the cake. It happens if you invest in the right markets and you’re investing in the right neighborhoods. The important thing is not to speculate. This is something we advise our investor clients all the time. Focus primarily on cash flow, it is my number one criteria. Don’t speculate and go into a market that has been appreciating and you go in there believing that trend will continue.
This is what happened to a lot of investors back in 2003, 04, 05 and 06, is they were investing “for that appreciation” and thinking that they were smart investors because the property values were going up. Those weren’t good investments. The properties weren’t generating cash flow. If it was, it was very small, maybe breakeven, possibly negative.
But then when the market turned in ’06 and into ’07, and especially into ’08, we saw people getting caught with their pants down. They were upside down on their properties, their mortgages were worth more than what the property was worth and they couldn’t keep the properties because the cash flow wasn’t high enough to carry the expenses. Don’t get caught in the same trap. Don’t speculate. Invest for cash flow. The appreciation will happen over time.
The L in ideal is for leverage. Leverage is a very powerful tool. It is the ability to borrow other people’s money to finance your properties. There are two myths out there with some real estate investors. Some people believe that you need a lot of money to invest. That’s simply not true. Others believe that investing is only for the rich. Again, that’s not true.
We have investor clients through Norada Real Estate Investments, my other company, purchasing properties for as little as $10,000 down. That’s 20% on a $50,000 property. With a few thousand dollars in closing costs and miscellaneous fees, they’re all in to a $50,000 three bedroom home for about $12,000. They’re getting great cash on cash return and a good positive cash flow from that property.
The power of leverage is that you get all the benefits of real estate with little invested. You have 100% of the depreciation, 100% of the appreciation. You have 100% of the benefits of amortizing that loan over time. You have 100% of the cash flow or income coming off of that property, but you only have to put 20% or maybe even less but 20% of the purchase price as a down payment in order to have 100% of all the benefits. That is the power of leverage.
Again, there are very few investments that you can control 100% of with such a small amount of controlling capital. Some people will say, “Hold on, Marco. You can purchase stocks with a margin account.” Yes, that’s true but you’re looking at 50% investment for 50% financing.
Stocks are very volatile. If they go up, that’s great, but if they go down and they go down below the point that you bought them at, then you get what’s called a margin call. That stock brokerage will come back to you and request that they get a certain percentage of however much that stock has gone down in value in the form of cash from you. You only have a certain number of days, I can’t remember how many it is, but you have to come up with that difference in order to keep your margin account in compliance with the terms of that margin.
When you combine income, depreciation, equity growth, appreciation, leverage all together, you do get the ideal investment. Like I said before, real estate has been the most historically proven wealth creator. If real estate only had three of these five factors, it still would be a fantastic investment. You have all five and that makes it a great investment to take advantage of anytime.
When is the right time? The short answer is now. You don’t wait for someday to come along. You don’t wait for the market to be “just right”. Procrastination is the silent dream killer. As author and lifestyle designer, Tim Ferris, says, “The stars will never align and the traffic lights of life will never all be green at the same time.”
It’s important that you get started today if you haven’t gotten started. If you’ve already started building your real estate portfolio, regardless of whether it’s only two properties or ten properties or 100 units, it’s a good idea to continue building your real estate portfolio to the point where you’ve reached your income goals and your investment goals. As Napoleon Hill says, “Don’t wait. The time will never be just right.”
In wrapping up, I want to encourage you to download our free eBook. It’s the Ultimate Guide to Passive Real Estate Investing. You can get that from our website, PassiveRealEstateInvesting.com. While you’re there, submit a question or a show topic. You can do that through the contact form or click the button on the far right where it says ‘submit voicemail.’ You can literally send us a quick voice message right from our website.
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