- Cash Flow
- Value Add
- Tax Benefits
I like to buy properties where the rental income exceeds my costs for mortgage, taxes, utilities, repairs and insurance. It is tough to apply this formula in cities like Seattle where home prices are so high, but it is possible with creative financing and/or rental management practices. I paid full price ($409,000) for a house in the Ballard neighborhood that currently cash flows over $2000/month, but that is another story. The savvy investor will always look for properties that generate a positive cash flow. Doing so will avoid disaster in a market downturn; anything else is speculation and not investment.
Most other investment vehicles must be purchased for their full retail value. In real estate, a small percentage of funds can control an asset of much greater value. Most mortgages require only 10-20% down, and a savvy real estate investor can control a property with much less than that. Assuming an investor actually put only 10% down on a $100,000 house, and that house appreciated 10% in one year, then the investor would have earned a 100% return on their invested capital.
In addition, the investor is earning equity by paying down principal every month. Because other asset classes do not have mortgages, this is a unique benefit of real estate.
The savvy investor will always attempt to purchase real estate for less than its market value. As an investor, I know how to add value to real estate to earn more equity. The individual investor can rarely do this with other equities. In real estate, I may purchase a fixer for 70% of After Repair Value, make an additional 20% investment in repairs and improvements, and now own the asset for 90% of market value. Instant equity of 10%!
Buying an asset for less than market value will also protect the savvy investor from market downturns. Network marketing, vending or online businesses may be good sources of cash flow, but they typically don't offer the opportunity to purchase the asset for less than its market value.
Few asset classes can match real estate for its significant tax advantages. Real estate investors pay some of the lowest taxes because of these benefits. The Internal Revenue Service mandates depreciation on rental property, which reduces the amount of taxable income annually. When the property is sold, the investor can defer paying capital gains taxes by doing a 1031 exchange.
If the investor defers taxes indefinitely, then upon his death, his heirs will inherit the property at full market value, wiping out any capital gains taxes owed at that time. No other asset class offers these kinds of benefits.
This is icing on the cake for the real estate investor, and should not be the primary focus of their investing. Seattle has been a great appreciation market. In the past three years, appreciation alone has generated a 200% cash-on-cash return for me on the Ballard house I mentioned above - despite the fact that I am not benefiting from principal paydown on my seller-financed mortgage.
The rule of thumb is that real estate doubles in price every 10-20 years.
Stock investors count primarily upon appreciation to earn their money, but real estate investors consider it a bonus after making money the other four ways. So can you understand why I am so jazzed about real estate?