Now it’s time for my favorite form of investing . . . real estate! It’s my favorite because I am a nerd and I love learning, and there is so much to learn in real estate!
This is a follow up to my last post on how to invest in index funds.
I’ll try to stick to a high level overview here and then dive into the weeds in future articles.
Real Estate vs. Index Funds
Real Estate = More Work: The big downside to real estate compared to index funds is that real estate is not usually completely passive. It is going to take significantly more work to set up. Once you are set up with a property the work decreases significantly, but it will still never be as passive as owning an index fund.
Real Estate = More Control: When you invest in index funds, you have no control over their performance. If a CEO gets caught in a sex scandal and tanks a stock, you can’t go fire that CEO. With real estate, you have much more control. You don’t need to sit around and wait for the market to go up, you can do something about it!
If the whole idea of investing bores or frustrates you, then just stop reading and invest in index funds; they are so easy! On the other hand, if easy isn’t what you’re looking for, if the idea of having to (or getting to) think about and control your investments sounds exciting, then read on.
What is Real Estate Investing?
Real estate investing involves purchasing “real property”, i.e. land, that will earn you money.
For the purpose of this article we are talking about rental property. This could be a house that you rent out, a duplex, an apartment building, a mobile home park, or anything else where you own the land and collect rent.
How to Make Money with Real Estate
There are 4 main ways that real estate pays you:
- Cash Flow from Rent
- Mortgage Principal Pay Down
- Appreciation
- Tax Benefits
1. Cash Flow
- Cash Flow from Rent
- Mortgage Principal Pay down
- Appreciation
- Tax Benefits
When a tenant pays you rent, you use that money to pay your immediate expenses (taxes, insurance, maintenance, etc), set aside money for longer term “capital expenses” (replace a roof, water heater, etc), and what’s left is your Net Operating Income (NOI). This will be equal to your cash flow if you own the property outright with no loan. If you do have a loan, then you need to subtract your loan payment from your NOI to get cash flow.
Rental Income – Expenses – Loan Payment = Cash Flow
Cash flow is the extra money that your property throws into your pocket every month. When the amount of cash flow coming in exceeds your personal expenses, you have reached financial independence! That’s a little different than the 4% rule.
Note that this money is not directly tied to the number of hours you work. In fact, if you hire a good property manager to take care of the day to day needs of the property, the amount of time you need to spend once the property is set up and running can be quite small. Probably not as small as with index funds, but not full time either. I own 3 small mobile home parks, totaling 20 doors, and I typically spend 1-2 hours per month reviewing statements and coordinating with my property managers.
Money that shows up in your mailbox every month that you didn’t have to work for? Now that’s nice! As Lonnie Scruggs said in Deals on Wheels, “Never let your mail carrier pass your house without leaving a check.” 🙂
But wait, there’s more! Cash flow also serves one other very important function: Cash flow is how you reduce the risk in real estate investing. To illustrate what I mean, let’s look at 2 examples:
Harry in a Hurry
Harry is really excited about real estate investing, and has saved up $40,000 to get started. Unfortunately his patience in finding a good deal does not match his excitement. He buys the first property he comes across with the following conditions:
- Purchase Price: $200,000 with 20% ($40,000) down payment
- Loan payment: $810 per month ($160,000 30 year loan at 4.5%)
- Rent: $1,200 per month
- Total average expenses including capital expenses: $600 per month.
- Cash Flow = $1,200 – $600 – $810 = -$210 per month
Harry’s cash flow is negative! Harry has to pay an average of $210 per month of his salary just to keep the place running and keep the lights on. That’s OK, he reasons, since if he adds in the principal pay down portion of the loan payment ($210 on his first payment) he would be actually breaking even. Plus properties have doubled in value over the last 8 years! When he adds appreciation on top of his “break even” deal, he reasons, he’ll be crushing it!
Unfortunately for Harry, a short while after purchasing the property another 2008-style bubble bursts. Instead of appreciating, the market value of this investment cuts in half and is now only worth $100,000. Since this is less than he owes on the loan he cannot sell the property. He is under water.
Then things get worse. The company he works for is forced to do layoffs due to lagging sales and Harry loses his job. He dumped his whole savings into the rental property, so he has no safety net. He can no longer afford the $210 per month that he needs to shovel into the property to keep it floating. Since he can’t pay the loan, the bank repossess it. He loses his investment and his life savings, all because he didn’t respect the cardinal rule of real estate investing: Your property must cash flow!
Patient Patty
Now let’s talk about Patty. Patty also starts with $40,000. Patty is also excited about real estate investing, but she wants to take the time to get it right. She builds a spreadsheet to help her quickly analyze properties. And analyze properties she does! She looks at hundreds of different deals until she finds a couple with terms she knows will work:
- Purchase Price: 2 homes at $100,000 each, with 20% ($20,000 each) down payment
- Loan payment: $405 per month per home ($80,000 30 year loan at 4.5%)
- Rent: $1,200 per month per home
- Total average expenses including capital expenses: $600 per month per home
- Cash Flow = $1,200 – $600 – $405 = +$195 per month per home or $390 total
Patty’s situation is different. Since she took the time to find properties that were priced appropriately given their rental performance, her cash flow is positive $390 per month. That is $600 dollars per month better than Harry, all because of the lower purchase prices.
When the recession hits, Patty’s properties also drop to half their value. Patty is also under water. Patty also loses her day job. That sucks, and looking for a new job is stressful, but at least the $390 of cash flow is helping to take the edge off her financial worries.
Most importantly, since her properties are cash flow positive, her properties pay for themselves and Patty will not be forced to sell or get foreclosed on at the bottom of the market. She can hang on to her properties and wait for values to come back up (which they will) before she ever considers selling.
Being able to ride out the low times and not get forced into selling your asset at the bottom of the market is the reason that you should make sure every property cash flows. Cash flow is your safety net.
2. Mortgage Principal Pay Down
- Cash Flow from Rent
- Mortgage Principal Pay Down
- Appreciation
- Tax Benefits
If you used leverage to buy your rental property (i.e. if you took out a loan), then some of your tenant’s rent is being used to make the loan payment. A portion of that payment is going towards paying down the principal of the loan. This will increase your equity in the property.
Equity = Property Value – Amount owed
Equity is roughly the amount of money you would end up with if you sold the property and paid off the loan. It’s the portion of the property that is counted in your net worth (you are calculating your net worth, right?).
As an example, if you put $20,000 down on a property that was worth $100,000, your equity would be $20,000 (ignoring closing costs for simplicity). If, over time, your tenants paid another $20,000 off the principal of your loan (“Thanks tenants!”) your equity would now be $40,000. You doubled your money!
Mortgage Principal Pay down is real money that is getting paid to you; however, unlike cash flow this money is not very liquid.
Liquid is a measure of how easy your money is to use.
Cash in your wallet or checking account is easy to spend, so it is liquid. Equity in your home, like money in your 401k, is not as easy to use so it is less liquid.
“Well what’s the point of getting paid money that I can’t spend?”
You can still spend it, it just takes a little more work to access. Think of mortgage principal pay down like a forced savings account. If you need to access it someday you would need to sell or refinance the property.
3. Appreciation
- Cash Flow from Rent
- Mortgage Principal Pay Down
- Appreciation
- Tax Benefits
Appreciation is when the value of your property increases. Remember our equation from earlier?
Equity = Property Value – Amount owed
Appreciation is another way to increase equity. While mortgage principal pay down focused on the “amount owed” variable, appreciation focuses on the “property value” variable.
Appreciation can be a very powerful wealth generator, especially when combined with leverage (once again, this just means you owe money on the home).
“Wait a second… leverage? How can taking out debt possibly help to generate wealth?”
Let’s look at another example to illustrate:
Debt Free Mary vs. Leveraged Bill
Mary and Bill both worked hard to save up $100,000 to invest.
Mary hates debt, so she uses all her cash for one $100,000 house. On the other hand, Bill uses his $100,000 to make five separate $20,000 down payments on five houses.
They are both very fortunate in that home prices go up by 10%. All the houses are now worth $110,000.
Mary is happy that her $100,000 investment added $10,000 to her equity, a return of 10% (not counting return from any rents she collected). Bill is ecstatic because his $100,000 investment added $50,000 to his net worth ($10,000 per house x 5 houses), or a 50% return.
Bill was leveraged at a ratio of 5:1, and thus his gains were magnified 5X.
Leverage ratio = purchase price/equity
This is the power of leverage + appreciation. You have the chance to earn very high returns. But be careful! Whenever there are high returns you should keep a lookout for high risk. The magnification goes both ways.
What would have happened in the example above if the property values went down by $10,000 to $90,000?
Mary’s equity would equal her property value of $90,000. She lost $10,000, or 10%, of her equity. That’s a bummer, but not the end of the world.
Bill on the other hand, would lose $10,000 in equity from each property, or $50,000! His total equity would now be $50,000 . . . he lost half his money!
It could have been even worse, if property values had dropped by $20,000 his equity would drop to zero. He lost all his money (assuming he sold). Even scarier, if it dropped by more than $20,000 Bill would owe more on the properties than they were worth. He would effectively lose more than he put in. This is called being “under water”.
As you can see, appreciation plus leverage is powerful, but dangerous.
A lot of people get so excited about the appreciation upside potential, that they forget about the first 2 wealth generators (cash flow & mortgage principal paydown) and only focus on appreciation with their real estate. If you do this you are not investing, you are speculating.
When speculating, you are betting that the price will go up. If the price goes down, and if you are forced to sell, you will lose your shorts.
The much safer way to chase appreciation is to first make sure that your property is cash flow positive. Cash flow is your safety margin. This will help you to ride out the lows and wait for property values to climb again before selling.
You will only lose money in a downturn if you are forced to sell.
Once you understand that your property should be cash flow positive to protect you in a downturn, there are a couple ways to set yourself up to enjoy the huge benefits of appreciation:
A. Forced Appreciation
B. Buying in the Path of Progress
A. Forced Appreciation
One of the best things you can do is buy a crappy property.
“Wait . . . what?”
You heard me, buy a crappy, run-down property. In other words buy a property with room for improvement. Since the property is so crappy, you should be able to get it for a very good price.
“Wait a sec, this is my hard-earned investment money we’re talking about! I don’t want to buy crap. I want to buy something nice!”
Nice things are expensive. Crappy things are cheap. And therein lies the strategy: If you can buy a property for cheap because it’s crappy, and then do some work to make it nice, it’s value will go up.
This is called rehabilitating (or “rehabbing” for short) a property.
Even if the housing market in your area didn’t go up at all, the value of your property did go up because you forced it to by rehabbing it. Hence the term “forced appreciation“.
This is what house flippers do. They buy crap, rehab it to make it nice, and then sell it for a profit.
B. Buy in the path of progress
Forced appreciation is a way to benefit from appreciation almost regardless of what the housing market does. That’s nice since you don’t have any control over the housing market . . . or do you?
Let’s talk about hot air balloons.
Hot air balloons have no mechanical means of steering. They can move up and down by messing with the temperature of the air in the balloon (hence the burner), and they can use some flaps to spin and face a certain direction. However, they cannot move forward, backward, left or right on their own. They just go where the wind blows them.
“Wait, that’s crazy! So they have no control over where they go? That sounds dangerous!”
I didn’t say they have no control. A good hot air balloon pilot has a lot of control over where they go.
“…but you just said they go wherever the wind blows them. You can’t control the wind!”
You are correct that you can’t control the wind.
“Then how on earth do they control where they go???”
It turns out that wind blows different directions at different elevations. All the hot air balloon pilot needs to do is find out which elevation is blowing in the direction she wants to go and she can raise or lower her elevation to put her balloon into that air current. Voila! She is blown in the direction she wants to go; she doesn’t even need to expend any energy to get there!
“That’s really cool! But what does this have to do with real estate investing?”
Just like the wind, property prices do not all change by the same amount and direction. They can vary by state, county, city, neighborhood, and even street to street.
If you can learn which area is headed in the direction you want to go, all you need to do is put your hot air balloon into that current (by purchasing a good cash flowing property in that area), and the market will blow you where you want to go.
The direction you want to go is up. How do you know which area is headed up? You buy in the path of progress.
How do you recognize the path of progress? You have to pay attention to what’s going on in your community. Is construction about to start on an awesome new park? Maybe that will cause the value of all the nearby houses to rise. Look for deals there!
One sign that you are in the right place is to look for new micro breweries. These facilities need low rent paired with affluent customers to succeed, so they tend to move into lower-end areas that are close to the clientele from the hipster and higher end neighborhoods. The red square in my picture above probably has several new breweries. They are the proverbial canary in the coal mine that let you know property values in that area are about to rise.
(Of course, I have absolutely no data to back this up, it’s just my unsubstantiated theory).
And what if you’re wrong about the appreciation? You might be. It won’t matter though, because you found a good property at a good price that is cash flowing, right? Even if you’re wrong, there are worse things than owning cash flowing real estate.
You might as well aim for some appreciation, but you should not bank on it as your only source of return on investment. Appreciation should be thought of more like a bonus that would be nice to get, but not necessary.
4. Tax Benefits
- Cash Flow from Rent
- Mortgage Principal Pay Down
- Appreciation
- Tax Benefits
The 4th way that real estate can make you money is with tax savings. For many people taxes are their largest expense, so if you can cut down on them that is a huge benefit.
Before I dive in, note that I am not an accountant, and you should verify all of this with your accountant.
Want to learn from someone who IS an accountant? A great read on this subject is the book Tax Free Wealth, by Tom Wheelwright, CPA.
Lower Tax Rates
Taxes from real estate investing tend to be accrued at lower rates then from typical W2 wages. I’ll touch on two types of real estate income here:
Rental Income: Taxes on profits from rental income are paid at your income tax rate. However, since they are considered passive income you do not need to pay social security tax or self employment on them. This is about 7% less tax than if you earned this via a W2 job, or a whopping 15% less than if you were self employed!
Long Term Capital Gains: As long as you have owned a property for more than 1 year when you sell it, you pay taxes on the profits at the long term capital gains rate. You’ll need to look up your rate based on your income bracket, but it is usually taxed at a significantly lower percentage than typical W2 taxes. For even more savings check out the “1031 Exchange” and “keep your properties until you die” strategies later in the article.
Deductable Business Expenses
When you invest in real estate, you are starting a real estate investing business. As such, any expenses associated with this business are deductible. One really cool aspect of these deductions is that they apply even if you are below the standard deduction on your normal taxes. This is because your business will only get taxed on the profit it makes.
Profit = Gross Income – Business Expenses
Tom Wheelwright goes into all sorts of ways that you can legally use this to your advantage. I’m not going to dive into all of the potential expenses that can be deducted, but I will touch on one of them: depreciation.
Depreciation
The IRS recognizes that buildings are not designed to last forever. In fact, they have determined that buildings last exactly 27.5 years (sarcasm intended). So they let you add a seemingly fictitious expense to your deductions called depreciation.
For most rental properties, you can depreciate the purchase price divided by 27.5. So for a $275,000 rental property, you can deduct an extra $10,000 per year above and beyond what you actually spend on expenses. So if this property made $10,000 in profit from rents, your depreciation would fully offset that and you would owe no taxes on it!
Tax free rental income, woohoo!
Hold up! Before you get too excited you should note that this is really just a tax deferral, not a full write off. In other words, when you eventually sell your property you will have to pay taxes on all of the money you depreciated at that time.
“What the heck Mr. DS! You get me all excited about a big tax break and then you tell me it’s just a deferral? That’s lame! Pay now or pay later, what’s the difference if I still have to pay???”
This is where the book I mentioned earlier by Tom Wheelwright comes in. Read that and talk to your accountant. You can do a few things to avoid the massive tax bill when you go to sell:
1031 Exchange:
If you sell your rental property and immediately use the proceeds to buy another rental property of equal or greater value, you can use what’s called a 1031 exchange to keep the deferral party going and kick the can further down the road. You will still owe all the taxes on your previous depreciation, and you will rack up more as you depreciate the new property, but at least you dodge the tax man for now.
This can be a great way to scale up into larger properties to increase your cash flow without paying capital gains taxes.
Keep Your Properties Until You Die:
If you pass away and leave your properties to your heirs in your will, all of the previous depreciation gets wiped away.
If you are reaching the end of your time here and want to leave a bunch of money to your kids (or to charity, friends, or anyone else), DO NOT SELL YOUR PROPERTIES. The tax man will come and want all of these depreciation taxes that have racked up over the years. In some cases you may owe more taxes than you can sell the property for!
Instead, leave your properties to your heirs (or your favorite charity), and let them sell the property after you kick the bucket.
Dying is really the best way to make all those depreciation savings permanent (sorry that sounded morbid). Read the Book Tax Free Wealth by Tom Wheelwright for more information.
Conclusion
If you put all 4 of these wealth generators together real estate can make a great investment for someone who is motivated and excited to learn. If that sounds like you, check out www.biggerpockets.com. Everything you could ever want to know about real estate investing is covered on that site.
If all of this sounds like too much work, just stick your money in the VTSAX index fund. With a high savings rate index fund investing will also get you where you want to go, and with a lot less effort to boot!
Whether you choose index funds or real estate (or something else!), just pick a path and start! In the end, if you can get to a high savings rate, you will get to where you want to go regardless of which investment path you choose.
What about you? How do you invest?