Part 3 in a Series: Investment Strategies for a Post-Peak Economy
Andrew Carnegie famously said that over 90% of the world’s millionaires made their fortune by investing in real estate. I don’t know how true that statement is, but Forbes states that 10% of the world’s billionaires made their fortune by investing in real estate. 1
One of the primary ways to build wealth is through wise investing that compounds over time. Real estate is perhaps the best way to build wealth.
This article, Part 3 in a series, examines the 5 ways that real estate investors make money.
1. Cash Flow.
Simply put, strong commercial real estate investments should generate annual cash flow, after paying all the property’s operating expenses, taxes, insurance, and mortgage.
In this article, I go into much greater depth as to why this should be the most important metric for real estate investing today. If your real estate assets are not generating cash flow, you really should read the article.
2. Equity growth through leveraged appreciation
When a stock appreciates, the value of each share goes up. The same holds true for real estate, although the added benefit is leverage, which amplifies the investor’s return.
Take the following example:
- A $400,000 property, purchased with a $100,000 down payment.
- Over time, the property may increase in value, say 10%, to $440,000. That’s great, but even better:
- The Investor’s return is actually 40%. The bank that loaned the $300,000 mortgage does not participate in the price appreciation of the property: the $40,000 appreciation / $100,000 down payment = 40% 2
NOTE – the risk of deprecation, when an asset’s value decreases, also magnifies the potential losses. These risks can be minimized through strong cash flow.
Understanding Cash-on-Cash
The term “cash-on-cash” is an important metric in real estate that is worth noting here. Prior to selling the asset, our cash-on-cash is the annual cash flow before taxes, but after all operating expenses, divided by our original down payment amount. When we sell the asset, we then combine the total cash flow of the property with the 40% return (our total cash out), and divide that by the original down payment plus improvement costs (our total cash in) to get our total cash-on-cash return. In non-real estate finance world, this metric is usually referred to as Return on Equity, ROE.
3. Equity growth through tenants paying down the loan principal
Using the same example above, after the first five years of ownership, the principal balance on the original $300,000 loan is now just over $275,000!
Here is the loan amortization schedule for a $300,000 mortgage at 5% rate on a 30 year loan:
So when combined with the 40% equity growth through appreciation, the $400,000 property that sells for $440,000 in year 5 has returned a total profit 3 of $64,514 on the original investment of $100,000.
That’s a 64.5% return over 5 years, just under 13% per year. And it is not an aggressive assumption whatsoever – it assumes asset prices appreciate at only 2% per year, right around the Fed’s target inflation rate for the U.S. economy.
This leads us to the 4th way real estate investors make money:
4. Inflation
Inflation helps real estate investors in three different ways.
Using the same example above, let’s say that real estate appreciates slightly higher than U.S. inflation, and the asset value goes up 3% per year. In Year 5, that’s a 15% total appreciation.
That $100,000 original investment has generated a 60% return, before we include any of the 5 other ways that real estate investors make money! Here are the calculations:
The numbers start to get silly when we have a moderate to aggressive outlook, that real estate value could rise, say an average appreciation rate of 5%:
There are two additional ways that inflation helps real estate investors.
Rent is a large component of the Consumer Price Index, CPI, which is the most widely used measure of overall inflation 4. So almost by definition, rents go up when inflation goes up.
This means that the rent you are receiving today will almost assuredly have the same real purchasing power in the future. And if rents go up faster than CPI, your future dollars will have even greater purchasing power than today.
Compare this to a fixed-income security, like a bond. When we buy bonds we know exactly what our future returns will be. But if inflation goes up faster than say the +/-1% that safe bonds are paying today, we are actually losing money.
And the third way inflation helps real estate investors is similar in concept, and relates to the time-value of money.
When we borrow money at a fixed rate, the money we use to pay it back in the future is less valuable than today’s dollars.
To continue with the earlier example, borrowing $300,000 today, at a 2% CPI inflation rate, is the equivalent of borrowing $271,719 five years from now.
Let’s use an example to illustrate this point: your rich and very generous friend offers to loan you $300,000 at a 0% interest rate, and she wants to be paid back in 5 years. You invest that money in starting a business, and in Year 5 hand her a check (with a a big hug and “thank you”) for $300,000.
But now when she goes to spend that $300,000, she can buy roughly the same equivalent that $271,719 buys today. Her dollars (or in our case the bank’s) are worth less in the future.
5. Tax Benefits of Real Estate
There are three major tax benefits to real estate investing. I will write in more detail about each of these in the future. This is a brief overview of:
- Depreciation – straight line, accelerated, and bonus accelerated
- 1031 Exchanges
- Opportunity Zone Investments
(NOTE: Several of my colleagues warned me about giving “tax advice.” All of these concepts are general, well understood tax advantages of real estate. Of course you need your own CPA, and of course this is general information, not tax advice specific to your circumstances. Disclaimer over.)
Depreciation:
Depreciation is an enormous benefit that isn’t widely understood. But you don’t need to be a CPA to understand, and once one does understand it, you’ll wonder why you haven’t been investing more money into real estate vs. other asset classes.Depreciation is a non-cash expense that our accountants include in our Profit and Loss Statements and tax returns. It is an enormous benefit because we pay taxes on our Net Income, and our Net Income is reduced and often even eliminated, by Depreciation. 5
This is precisely why many professional real estate investors pay very little in Federal Income taxes. Let’s go back to the $400,000 property example. Let’s assume this savvy investor has found a property at a 6.5% Cap Rate (see this article for a deep dive on cap rates and how to find 6.5% returns). The Net Operating Income is by definition $26,000 (Cap Rate = NOI / Value). After paying the annual mortgage, the investor put $6,674 in their bank account for the year. 6
Using straight-line depreciation, the most simple form of deprecation, the investor pays no tax on the income generated from the building. Hers is a simple P&L Statement to illustrate:
Pick your tax bracket – say 35%. By paying zero taxes on your $6,674, your essentially received a 35% higher return than a similar investment that is subject to your Federal Taxes.
Accelerated and Bonus Accelerated Depreciation will be discussed in a future article. Same concepts, but bigger tax advantages in the first year(s) of ownership.
1031 Exchanges
When real estate assets are sold, the IRS Tax Code 1031 allows investors to re-invest the proceeds into another “like kind” investment, and pay no taxes on the gain.
If an investor buys say Apple stock totaling $400,000, and sells it later for a $40,000 profit, the investor will pay a Capital Gain tax on the profit, even if it is re-invested in another stock.
The real estate investor who takes their proceeds and re-invests in another property (wisely using leverage to amplify their purchasing power), will not pay any Capital Gains tax. This allows them to keep growing their real estate portfolio, tax free!
Opportunity Zone Investments
Opportunity Zones are new to the tax law, and are meant to encourage investment and development in lower income neighborhoods.
Every state has designated census tracts (neighborhoods) that are located within an Opportunity Zone.
For people who invest and develop in these neighborhoods, an Opportunity Zone tax benefit is somewhat similar to 1031 exchanges. They allow the deferral of capital gains taxes.
The biggest difference – and new to the tax law – is that non-real estate assets can be sold, and invested into real estate. So back to our Apple investor, if she were to take her $40,000 gain and invest it in a property in an Opportunity Zone, and if they follow all the guidelines, they would delay and reduce their capital gains tax for many years.
There is much more nuance, complication, and rules around Opportunity Zone investments, far too much to cover in this article. You’ll need to work with your CPA on these, and there are plenty of published articles on Opportunity Zone investments that are worth researching. I’ve currently bought two Opportunity Zone investments, and am working with clients and investors to acquire more.
Conclusions:
Real estate is unique among investment asset classes, in that there are five different ways that investors make money.
Compare this to investing in stocks: a stock that pays a dividend and appreciates in value, generates two ways to make money. If that stock is bought within an IRA, 401(k) or other tax-advantaged account, there are three ways that stock investors make money.
But real estate is better than a 401(k), primarily for control and tax-free income that can be spent today, or re-invested for the future.
While other asset classes are eroded by inflation, real estate benefits from inflation. Real estate investments protect the investor’s dollars, so that future buying power is greater than it is today, not less.
And finally, think about this: what is your greatest expense? Hint: *taxes*
Through wise real estate investing, investors can reduce, and possibly even eliminate many of the taxes that otherwise erode our investment returns. This allows for much greater compounded returns over time.
When all 5 of these benefits are combined within one asset class – real estate – it’s no wonder that many of the world’s billionaires made a significant percentage of their fortune by investing in real estate.