Wednesday, November 27, 2013

Why Investing in Real Estate Works

When you look at the wealthy people in our nation, the majority of them made their money in real estate. It always has been and always will be the most stable and profitable investment around. What makes it so good? There are two reasons. First, land is a finite asset. They aren't making any more of it, so it will always be a limited supply. Second, people will always need a place to live. During tough times folks may find a way to live without cell phones or a car, but they will always need a place to call home.

There are many types of real estate to invest in and many ways to invest. Some people think buying a house and flipping it is investing. However, this is really more like generating income. True investment is long term and focuses on building equity. To be successful in real estate investment you must be patient and understand the big picture. Let me illustrate this with an example. Suppose you have a rent house that rents for $800.00 per month and the monthly payment including taxes and insurance is $650.00 per month. What are you making? Nearly everyone will say you are making $150.00 per month if you have no repairs or no vacancies. That doesn't seem like enough money for the hassle and so they never invest. However, this thinking is completely wrong. The $150.00 only represents your cashflow which is just a portion of your entire return.

Here is what your actual monthly return would look like:
Cashflow - $150.00                         ($850-$650)
Appreciation - $333.00                    (Based on $80,000 value and 5% annual appreciation typical for Lubbock)
Mortgage Reduction - $50.00           (Based on the first year of a 30 year loan)
Income Tax Savings - $50.00            (This is an estimate that depends on your tax bracket)
Total Monthy Return - $583.00
Wow! That's exciting stuff! I owned four rental properties before I really put all of this together. You can see there is a huge difference between the $150.00 return most people assume and the $583.00 return that is actually taking place. That return is awesome and better yet it will only increase with time. Rent will continue to go up and drive your cashflow higher. Over time you begin to appreciate on your appreciation, so that number always grows like compounding interest. Your mortgage reduction increases with each payment as you pay more principal and less interest. So, the $583.00 per month should be the worst you ever see with this particular property. Imagine if you had ten of these properties doing this for you every month. What if you had one hundred? Then you begin to see the power of investing in real estate.

There are some key concepts you can see through this illustration. First is the power of leverage. In the example above I can make $333.00 per month in appreciation on an $80,000.00 property without needing $80,000.00 to buy that property. The appreciation is the same for me if I buy a house outright with cash, or if I finance the whole thing. It doesn't matter. If I wanted to make a return off of a million dollars in the stock market I would need to find one million dollars first. If I want to make a return off of one million dollars in real estate, I could do that with only one hundred thousand dollars, and probably even less.

Second, you actually save on your taxes by owning property. How can you save on taxes when your properties are making money? The answer is through depreciation. Remember there is reality and then there is the way the government looks at things. In reality your investments continue to appreciate in value, but for taxes the IRS allows you to depreciate them. You can depreciate a property over a life of 27.5 years. For our $80,000.00 property we would deduct the value of the land, say $10,000.00 and give us a depreciable amount of $70,000.00. Divide that amount by 27.5 and you can deduct $2545.45 per year in depreciation. You also deduct for repairs, taxes, insurance, and interest. After all those deductions and depreciation you should show a loss that you may be able to use to offset other income and save on your taxes.

Third, real estate investments are indexed for inflation. As inflation rises, so do your rents and property values. It is very rare to see properties go down in value unless they were overvalued to begin with. The rare years where real estate loses value are typically followed by years of higher than normal appreciation that offsets the short-term drop.

When I began in real estate eleven years ago, I didn't even own a home. Since then I have purchased 36 rental units and a home. I no longer worry about my financial future. The formula for my future success is already there. All I have to do is be patient and let the system work. It's no get rich quick scheme. It's hard work invested in the right place.

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