Real estate has a number of benefits that make it an attractive asset class. Most people only look at the cash flow and equity portion of owning real estate but there are other benefits that make real estate an excellent investment.
- Cash flow that is above and beyond the cash flow needed to for the mortgage, taxes, insurance, and reserves provides passive income;
- Paying down the mortgage every month further increases your net worth;
- Real estate has numerous tax benefits that other investments do not have;
- Real estate tends to appreciate 3-4% over time, which increase your equity.
Cash Flow
Cash flow is the profit generated from renting out your property. If rent is $1000 per month and expenses are $800 then $200 is your cash flow for the month. Many people invest in real estate for the long-term cash flow. When running numbers on a real estate deal it’s important to calculate “true” cash flow, which is the rental income minus the mortgage, property taxes, insurance AND reserves for maintenance and vacancies. Not setting aside some money from the monthly rents is a recipe for disaster. What happens when the AC unit needs to be replaced for $5,000 or when the roof has to be replaced for $12,000? This is why it’s important to have reserves. When running numbers on a property you should think about the long-term averages of various expenses such as maintenance. Month-to-month the profits from rental properties can be lumpy as some months there are no maintenance expenditures, while other months there are a lot. The “correct” amount of money to set aside for maintenance and vacancies will vary based on the age, size, finishes, and fixed expenses of the property.
The great thing about fixed expenses is that these expenses, for example the mortgage payment, stays the same (if you have a fixed rate mortgage) while your rents typically increase making it easier to cover your debt payments on the property over time. Note that costs for things like maintenance and insurance will go up over time so not all of the rent increase is pure profit, but a good chunk of it is. Having positive “true” cash flow is a great way to lessen the risk of your investment. By having a buffer rents can drop, and you should still at least be able to break even every month on the property without having to come up with money out of your own pocket to cover an expense.
Debt Paydown
If using debt to purchase a property then every month the debt gets paid down in the form of mortgage payments. A typical mortgage is amortized, so at first most of your mortgage payment goes towards interest, but over time more and more of the payment goes towards principal payment. Using more and more leverage (debt) can increase your return on investment at the risk of becoming too over-leveraged and not having the cash flow to cover your debt if your real estate investment hits some speed bumps. There are many people who wish that they used less debt in the lead up to the housing crisis of 2008.
Tax Benefits
Real estate has quite a few tax benefits that help offset the cost of owning such a high maintenance asset. Operating expenses such as insurance, property taxes, maintenance, and property management are expenses that can be written off on your taxes. Don’t go too crazy on over-improving your property to avoid taxes as needless expenses that don’t increase the value of your property is a waste of money. If you made $1,000 and put all $1,000 into property improvements that don’t increase its value then you just blew $1,000 instead of keeping that money in reserves and maybe only paying $200 in taxes on that $1,000.
Depreciation is another benefit of owning real estate. You may be thinking “Wait! Real estate depreciates? I thought everyone buys it because it appreciates.”. To understand what is going on here we have to separate real estate into “land” and the “structure” that sits on that land. Land doesn’t “break-down”. After all, When was the last time you had to call a repairman to fix worn-out land? However, the structures that sit on that land, like houses and garages, do wear down over time and require repair. To account for this the government allows you to depreciate the cost of the structure (the keyword being structure not land) as a write-off on your taxes. It’s important to note that this write-off in most cases can only lower the income from other passive income (such as other real estate income), but can not be used as a write-off on income such as wages. As with all things that have to do with taxes, there are some exceptions that you should talk to your accountant about.
Depreciation can work in a few different ways. Typically you use “straight-line” depreciation on a residential structure over the course of 27.5 years and 39 years for a commercial structure. After that point the structure is considered fully depreciated and you no longer get a depreciation write-off. There’s also accelerated depreciation, which allows you to write-off the cost of the property at a much faster rate. This is typically done when more of a tax write-off is needed. This is all very beneficial while you are holding the property. The trade-off is that if you sell at a profit you must pay taxes on “depreciation recapture”. The solution? Either don’t sell the property, or perform a 1031 exchange. We’ll cover what a 1031 exchange is and how it works in another article, but basically by selling a property and buying another property with the money from the sale in a set amount of time you can avoid capital gains taxes and depreciation recapture.
Talk to your CPA for more information on these tax benefits and more!
Appreciation
Mark Twain once said “Buy land, they’re not making anymore”. This quote is true to an extent. Yes, more land is not being made (volcanic islands notwithstanding), but what matters most is the location of that land and your rental property on top of said land. For instance, why is New York City so expensive to live in? Because many people want to live there and there’s a finite amount of space. The same applies to Hilton Head and the surrounding area. People want to move here because of the great weather, lifestyle, and job opportunities. This in turn causes the price of real estate to appreciate due to demand exceeding supply.
It’s important to note that real estate appreciation is speculative and no one can predict what appreciation will be in the future. Some years values go up, stay the same, or sometimes even go down, but over the long-term the 25 year average for home appreciation across the country has been just under 4%(1). However, with leverage your returns can be even higher. Here’s an example:
If you buy a house with cash for $100,000 (I know it’s unrealistic, and this calculation doesn’t include closing costs, but let’s just keep the numbers simple here) and the property appreciates by 4% over the year then you just made a 4% return on investment (ROI). Now let’s say that you instead put 20% down ($20,000) and finance the rest of the purchase. Fast forward a year later and the $100,000 house has appreciated by 4%. Your ROI is no longer 4%. It is 20%! This is because you put $20,000 down and the house increased in value by $4,000 so $4,000 divided by $20,000 times 100% equals a 20% ROI.
Well there you have it! These are the main reasons that real estate can make for a great addition to your investment portfolio.
(1) https://www.blackknightinc.com/black-knights-april-2019-mortgage-monitor/
This article is not investment, legal, or tax advice and is for informational purposes only