I find that the first question to ask oneself before venturing into something new is always “Why?”. Because if you understand the “why”, it keeps you pushing forward even when the going gets tough… A good “WHY” is to build something and pass it on to your kids so they can have a comfortable, risk-free life. Another good “WHY” for investing in general is to attain FIRE – Financial Independence Retire Early… It’s something a lot of professionals have been targeting lately- to get to the point where they can work because they want to and not because they have to, to be able to define how many hours they want to spend at work and how much time they want to spend traveling or with family doing the things that have been on the back-burner for so long. To get to that point, you have to generate enough in passive income to be able to cover your annual expenses without tapping into retirement savings (or have enough in retirement savings to tap into it at a reasonable rate and still have it last you as long as it should).
This is where Real estate investing comes in…
When you only have a few hundred bucks coming in every month after expenses, real estate investing may not seem so attractive, but it’s always important to factor in all these components when you are assessing returns. Let’s delve into each individually…
The benefits of investing in Real estate are FOUR FOLD:
|Tax free rental income|
|Debt pay down by your tenant|
- Tax free rental income: One of the most important factors to consider when assessing a potential rental property for purchase is COC – cash on cash return. Put very simply, this is the ratio of annual before tax cash flow (Rent-expenses including mortgage payments, property taxes, insurance) to total amount of cash invested (down payment + closing costs) expressed as a percentage. Now in most cases, particularly if you have leveraged your money and taken a mortgage out on the property, this is tax free money due to paper losses from DEPRECIATION, a real estate investor’s friend and one of the many ways the tax code favors real estate investors. A good investment property usually fetches 8 – 12% in COC return that is tax free, already pitching it against returns from S&P 500 index funds. But there is more…
- Remember, if you have leveraged money in a rental property and taken out a mortgage on it, then your tenant is paying towards the principal every month, increasing your equity in the property, an oft forgotten return on investment. Let’s say this is usually around 3-4 % of your initial investment in leveraged properties.
- And hopefully your property is appreciating in value since your purchase, national averages are around 3 – 4%. But if your money is leveraged, meaning you only put down 20% as a down payment, then your actual ROI (return on investment) is around 15% conservatively. Again this is in a market that is trending upwards, which is the general trend if you have a buy and hold strategy.
- And lastly, my favorite- tax savings that are in addition to your tax free cash flow. In most rental investments with a mortgage on them, thanks to Depreciation and other expenses the government allows you to deduct legally, your year end numbers show a “Paper loss” that under the right circumstances you may use to offset taxes on other income, another factor to consider in your ROI. When you factor in Cost segregation, bonus depreciation – things can get very exciting, again proving that the tax code does reward real estate investors for stimulating the economy.
Since everyone understands numbers better with an example, let’s run some numbers… Say you put 40,000$ (20%) down on a 200,000$ single family home rental that rents for 2000$/month.
- Your monthly expenses PITI (principal, interest, property tax and homeowners insurance costs) are around 1200$; but factoring in vacancy and other maintenance and capital expenses, possible HOA and property manager fees – let’s say your expenses are 1500$ out of pocket (very conservative numbers) – your COC ie cash on cash tax free gains each month are around 500$, which translates to 6000$ per year, fetching you a decent 15% COC. While filing taxes the following year, thanks to DEPRECIATION of rental property value that can be claimed on Schedule E where you report rental income and expenses, this rental income gets sheltered as tax free gains.
- Your tenant pays around 200$ towards the principal each month, 2400$ annually which is a 6% return on your initial investment.
- Assuming the property appreciates by 3%, that’s an increase in 6000$ in year one, which is an additional 15%.
- Factoring in paper losses (depreciation and other expenses the IRS allows you to legally deduct as business expenses required for your rental investment) of around 2,400$, which is again a very conservative assessment, that is an additional 6% return on investment. Giving us a grand total ROI of 42%. Now in a different market where rents are lower or property taxes higher, or in another year when interest rates are higher, your ROI may drop down to around 25%… In yet another market with higher property appreciation, your ROI may be above 50%.
As you can see, the ROI for real estate investment done right beats S&P returns without a doubt.
So the real question then is not “WHY” invest in real estate but WHY aren’t you investing in real estate??
And for those of you thinking of the hassles of fixing a leaky faucet or toilet, and for those who have heard horror stories of tenants trashing a friend’s rental – stay tuned….