Why you should invest in real estate
Photo by CHUTTERSNAP
Beginning in 2016, I have been investing in real estate. Here is a list of the positives aspects of real estate investing. Pairs well with: Why you should not invest in real estate.
As always check out the obligatory disclaimer.
Most people contribute to their 401k (or other tax shelter option like 403b - Ill use 401k as a synonym for all tax shelter plans) through their employer. This is a no-brainer. Especially if your employer offers a “match” which is basically free money. I contribute enough to my 401k to maximize my employer's match percentage.
However, there are specific limits to what you can invest with your 401k. Most employer’s plans allow you to allocate your fund into mutual funds or index funds.
Investing in real estate allows you to diversify your investments outside of the stock market. The stock market can be pretty volatile. I know people who tried to retire during the 2008 recession and were in a tough spot as their stock portfolio was down greater than 25%.
Real estate appreciates in value year-over-year (at least in areas where you’d want to invest). And if you choose to invest in a relatively resilient area, the value of your real estate assets will likely be less volatile than your investments in the stock market.
There is a psychology to saving money and investing. Managing your own psychology might be the most important part of a successful investment strategy.
Investing in real estate forces you to save. This is best explained by an example:
Let's say you unexpectedly get $5000 (tax return, bonus, inheritance). What should you do with the money? You have many options. Most will spend it. This is why most people don’t build wealth. They spend everything they earn.
But let's say you are smart and want to invest your $5000. You still have many options. You could invest in the stock market. However, you can sell stock pretty easily. So when you see that instagram ad and need to have a new couch, grill, quad … just sell your $5000 in stock. Afterall, receiving the $5000 was unexpected and doesn’t count toward your budget (assuming you even have one, cough-Julie).
Investing in real estate is illiquid. So even if you want the shiny new hotness, you can’t sell your building to get it (I guess you could but the barrier of selling makes it not worth the effort). This is why I see real estate investing as “forced savings.”
There are many tax benefits to investing in real estate. Here are some.
The most important is depreciation. Folks think depreciation is complicated. It can be. However, the high level idea is that the government thinks your building losses value overtime due to wear and tear - your assets depreciates. And you can offset your income (lower the tax you need to pay) with the depreciation of the asset.
The reality is real estate values actually increase over time (appreciate). Yes, you do have to upkeep but these expenses are offset as deductions. I like to think of depreciation as the government's way of “subsidizing” investment in real estate. Regardless if your building’s value increases over time, depreciation lets you offset your income significantly.
But by how much? Here is an example: You bought a building in 2020 for $500,000. The land is worth $100,000 and the building $400,000. Usually you can depreciate the asset over 27.5 years. This means you take the $400,000 (you can’t depreciate the land value) and divide by 27.5 = $14,545. So, if you make $10,000 in rent income you can offset this income with the depreciation. In this simple example you’d have a $4,545 loss. And remember, this “loss” carries forward on your next year's return. This is likely how Donald Trump had a $46.1 million loss in 1985. I’d bet the majority of this loss was depreciation.
In practice, depreciation allows many real estate investors to pay low or zero taxes for many years into their investment.
There are several important considerations to keep in mind about depreciation. Read more here.
In general there are two types of real estate investors: cash flow and appreciation.
Appreciation Appreciation investors are speculators. They invest in high growth areas and hope the value of the asset increases rapidly over a short period of time. “House flippers” are a subtype of appreciation investor that use “forced appreciation” (aka fix up the place) to increase the value of the asset and then sell it at a higher price. You can read more about appreciation investing here
Cash flow I am a cash flow investor. I am biased but I think this is a better long term strategy. If your goals are to build wealth overtime, cash flow investing is the way to go.
What is cash flow investing? In simple terms, cash flow investing is finding an asset that makes more in income than it costs. This seems obvious. But contrast this with house flippers who have huge upfront costs before they sell and get their payout.
Another example: A 12 unit apartment complex makes $100,000 in rent income per year. Expenses are $50,000 (utilities, garbage, etc). The mortgage payment is $25,000 total per year. Therefore the cash flow is $100,000 - $50,000 -$25,000 = $25,000. This means you’ll have $25,000 in cash in the bank at the end of the year.
I like finding cash flow positive buildings because they reinvestment of the cash produced. This causes compounding of your investment
How’s this conversation going to go:
Me “Hey broker, can I borrow $1 million to buy Apple stock?”
Broker “What’s your collateral?”
Me “Hmm...my good name?”
Not going to work. Real estate investing allows you to use leverage in the form of a loan. The bank will give you a loan to buy a million dollar property (as long as you and the investment meets their criteria). If you default on the loan they have collateral - they will repossess the building, sell it and get their mortgage back.
You can use leverage for some types of stock market investing (futures contracts for example). However, this is not available to most (probably for good reason). Leverage is an accessible and powerful tool for the real estate investor.
A real estate asset can be a hedge on inflation
This is because the value of the assets and the income generated (rent) usually increases with inflation.
If I have $100,000 in the bank and inflation is 5%, I'll lose 5% in buying power every year. However, my $100,000 building will usually increase in value to $105,000 in step with inflation.
Think of the $1 million loan I mentioned in the leverage section. With every loan payment, a part of the principal is paid down. This starts off small due to the amortization schedule. But it adds up. Especially for a large loan. And remember, the rental income pays it down if you are a cash flow investor.
In fifteen years when my oldest son goes to college (or starts a business like his ol’ man) I'll “own” a large chunk of most of our buildings as the mortgage is mostly paid down every month by the rent income. This is the power of equity growth.