5 Ways Real Estate Makes You Money
When you look at the wealthiest people in the world you see that they all have something in common: They hold significant amounts of investment real estate. In fact, if you dig a little deeper you will soon find that real estate is the main reason they became wealthy in the first place. How does real estate enable you to build wealth and live life on your terms? Most aspiring investors have a very shallow understanding of how real estate investments work. For instance, a common myth is that real estate makes you money by creating positive cash flow. While that's one of the benefits of owning investment real estate, you are just beginning to scratch the surface.
There are 5 Ways Real Estate Investments Make You Money so let's go through them one by one so you can understand why real estate is the investment vehicle of choice for the wealthy.
Let's start with the one you are probably familiar with. Positive cashflow is the net return the property produces in a year after all expenses and mortgage payments are taken out. At a fundamental level, an investment property is a small business. Money comes in through rent and money goes out through property taxes, insurance, repairs, vacancy and mortgage payments. What's left over is the net profit otherwise known as positive cash flow. If you divide the cash flow the property produces by the amount you invested to buy the property you get the property's cash-on-cash return. For example, if the down payment plus closing costs on a property is $45,000 and after all expenses the property produces $3600 in positive cashflow, your cash on cash return is 8%.
When you hear people compare real estate returns to stock market returns they are usually using the cash on cash return metric. While positive cash flow is great, it is just the tip of the iceberg of how real estate increases wealth. Next, let's go over the other 4 ways real estate investments make you money.
Unlike other financial markets, real estate markets are fundamentally inefficient because price decisions are driven by emotions. You could have two indentical homes in the same block of a neighborhood and one will sell for significantly less than the other. The reason for this price difference is not that the properties are worth different amounts. The reason is that one of the Sellers might be in a financial situation where a faster sale for less money is more desirable than a slower sale for more money. Price isn't the only term that matters to owners of real estate.
Therefore, a savvy and well capitalized real estate investor could take advantage of the inefficiencies in the market and buy a property at less than its fair market value. The difference between the market value of the property and the purchase price is called equity capture. For example, if you buy a property that's worth $200,000 for $175,000, you capture $25,000 of instant equity. This equity is unlocked when you sell the property or pull cash from it through a refinance.
Debt Pay Down
As your Tenants pay their rent monthly and you pay the mortgage on your investment property, a portion of that payment goes toward the principal reducing your mortgage balance every month. For example, let's say you purchase an investment property for $200,000 and put down 20%, borrowing $160,000 at 3.5% for 30 years. Over the first 12 months, your mortgage balance would decrease by a total of $2810 providing yet another source of return from your investment property. The debt pay down from your investment property works like a "forced savings" plan. Your net worth increases every year by that amount but it's not liquid so you can't spend it away. Over the long term and over multiple properties, debt paydown becomes an automatic way your investment property makes you money while you operate it.
Did you know that real estate is the only asset where you're allowed to keep two sets of books ... legally? It's true! On one hand, you have what really happened during the year: Rent came in, Actual expenses got paid out and Actual positive cashflow was left over. On the other hand, you have another set of books that allows you to deduct an expense that you didn't actually have to pay. That expense is called Depreciation expense. The logic goes that every year you own a piece of property it "wears out" so to account for this depreciation, you get to deduct this expense from your income, reducing your tax liability. In some cases, the depreciation expense can wipe out the entire income which means you owe no taxes and in others, it can even cause a "paper loss" on a property that actually made you money. Now do you start to understand why the wealthy like to own real estate?
If you've been around a while and paid any attention to real estate prices you have probably noticed that they tend to go up over time. There are exceptions, of course. I'm looking at you Great Recession of 2008. If you had a home built 5 years ago and own the empty lot next to it, you couldn't build the same exact house on that empty lot for the same price as your existing home. That is because the cost of land, labor and materials has gone up due to inflation during that time. Since the principal source of new supply of properties in the market is from new construction and the builder has to sell at increasingly higher prices due to rising costs, it provides a "natural" appreciation that happens. Of course, there are other factors at play that can accelerate the appreciation like high demand for an area due to it's perception as a "hip neighborhood" or "the area with the best schools". And vice versa. Property appreciation is the critical way a property makes you money when it comes to wealth building.
In order to understand why Property Appreciation is key to building wealth, it's critical to understand Leverage. From physics, we know that leverage is the ability to do more with less. In real estate, leverage is your ability to control 100% of the asset with just a fraction of that in capital (20-25%). Okay but what does that have to do with building wealth? It's the magic that multiplies your money and helps it grow much faster than it would otherwise. Let's take that same property you purchased for $200,000 and put $40,000 down. If your property goes up in value 10% and appreciates by $20,000, your rate of return on that appreciation is actually 50%! The reason is that you only invested 20% of value to buy this asset but get to enjoy 100% of the appreciation. A $20,000 increase in value over your investment of $40,000 is a 50% return. In this scenario, Leverage will multiply any appreciation rate by 5x. Now, let's bring this home. Think about property prices 10 years ago and the value of those same properties now. Many of them may have doubled in value or more. What happens what that outcome is increased 5-fold by leverage and you own a portfolio of such properties over the long term?