Real Estate: Buying Into Wealth
In my last post, I briefly mentioned why I love real estate for investing. As an asset in your portfolio it provides distinct advantages that you simply can’t get from buying an equity or bond. Because my readership is mostly young professionals, I felt a follow-up is necessary since we have the most time to benefit from the wealth building potential of buying property.
First though, it’s important to note what real estate is not. Real estate is not liquid. At all. When you buy a piece of property, you need to realize that you will likely hold this asset for at least five years. There is also a time commitment involved with property – whether it’s your primary residence or you have tenants in a rental situation, you must maintain the property. That comes in the form of keeping your appliances up to date, ensuring the plumbing is in working order, and that the home is safe and hospitable; those responsibilities are increased tenfold when you have a renter. You might be able to live with an ice maker that sounds like a T-Rex when it makes ice, but your renter will not. On another note, can we seriously get an ice maker that roars like a T-Rex when it drops ice into the bucket? Now let’s talk about other million dollar ideas.
Think Like an Investor
Real estate can be classified as three different “plays” just like a stock: short, neutral, and long. I’m only going to touch briefly on it because the Financial Samurai has an awesome and in-depth look at these plays.
Short Real-Estate: You’re a renter. Theoretically, you are hoping that prices fall; however, we all know pragmatically you would probably buy if you could but for some reason or another you haven’t. Realistically, being short real estate just means you don’t have any skin in the game.
Neutral Real-Estate: You’re a primary homeowner. You have a single piece of property and you live in it. Whether prices fluctuate up or down, you’re overall unaffected because you don’t plan to sell. You do still have downside risk because home prices are a lagging indicator of the economy, so if your house value is dropping you likely have decreased job stability.
Long Real-Estate: You have a primary residence and one or more investment properties. A downward trend on property prices directly impacts your overall net worth; conversely, an upward tick positively affects you and allows you to take advantage of it because selling your property doesn’t leave you homeless.
Why Real Estate Rocks
So now let’s dig into a few of the benefits real estate can convey to an owner. The most obvious choice to start with the myriad of deductions available. The most popular and well known is the mortgage interest. This is essentially a subsidy paid to homeowners to offset some of pain felt by getting a new mortgage (where you pay mostly interest and very little principal). The interest deduction is one of the most used deductions on tax returns and is incredibly easy to figure out. Take the amount you in mortgage interest and multiply it by your marginal tax rate. Paying $10,000 in interest your first year and being in the 25% marginal bracket grants you a $2,500 deduction towards your adjusted gross income (AGI). Easy. There are others, you can deduct a portion of the private mortgage insurance if your loan-to-value (LTV) is less than 80%, you can deduct some of the property taxes. There are a few credits also; however, not many and they generally require some sort of capital outlay – like adding green energy features to your home.
Another great thing about property is that it hedges inflationary pressures. Once you lock in a mortgage, you get a fixed principal to pay back. That means any raises, or even cost of living adjustments, make you better off since you’re now paying off a relatively cheaper debt. That’s not where it stops though, property has an added level of inflation protection too. Prices are relative. If you start shopping for a house and notice they’re more expensive, that means your property is likely worth more too. So long as you’re neutral or long in property, you get a wash when it comes time to purchase any new primary residence.
So let’s shift the focus to just investment property, because that’s where the real wealth is developed. Once you buy an investment property, you become a business owner and you can claim various business expenses. Did you repair a leaky faucet? You can deduct that. Paint the interior and exterior? Deductible. Take out advertising space or print out flyers when you have vacancies? Yep, that too is deductible. Let’s keep it in perspective though, you’re still going to spend more than you can deduct; however, it’s a nice little bonus come tax time to reduce your AGI for things you had to do anyway to keep renters in the property.
And on the topic of renters, how about that cash flow? Renting is the best way to increase your wealth. Rental income is a way to diversify your cash flow which in turn decreases job lock and overall risk profile and it’s semi-passive so you still can work your full-time job or run your business. Cash flow is king, so if after expenses your rental is only providing you $50 a month you’re still better off. You can always refinance or re-amortize later to provide a better cash flow. In the meantime, you’re still getting an extra $50 a month and you have a tangible asset that, should another run up in prices happen, you would be able to sell and take advantage of the capital appreciation.
The bottom line is real estate, if taken care of, can be a powerful weapon in your wealth arsenal. It’s a tangible asset so you can see a direct reward for the effort you put into maintenance and marketing to keep your units occupied at all times. However, it still is an investment, an educated gamble. It takes work to find the right property, make it marketable, and then it still takes a huge capital outlay to actually purchase that second property. However, the rewards are immense and here at the Cash Flow Celt, it will always get two thumbs up.
So readers, do you have multiple properties, and if not, do you have the drive and eagerness to purchase an investment property? If you do own, what were some of your experiences and has real estate lived up to its reputation? Let us know in the comments below.