My first real job out of college was in public accounting performing financial audits of companies. Being exposed to annual reports and 10K’s, it was natural for many of us in the industry to flock to the stock market to invest our disposable income. It was four years after entering the work force when I finally mustered up the courage to move out of my parents’ house and get my own place (actually my girlfriend at the time wanted to move in together). It was the sale of this first “investment” that got me realizing the benefits of real estate investing. Here are the top FIVE potential benefits of investing in real estate:
- Appreciation (with Leverage as a multiplier)
- Cash Flow
- Tax Benefits
- Equity Building through Loan Pay-down
- Inflation Hedging
After living in my first place for five years, I decided it was time to sell. I discovered the unit had appreciated by 87% in those five years. To make things even better, I had purchased this condo with only 5% down. So even taking to account my sales commissions, closing costs, improvements I made to the unit while there, I had a total return on investment of over 400%. The gravy on top was that my gains were tax free since I was the owner-occupant for five years! It was this real estate play that got me convinced that real estate could be a great way to diversify my investment portfolio with the opportunity for appreciation.
2. Cash Flow
I admit, there was luck involved in the appreciation of of my first property. As such, I started looking for investments that would have good cash flow (or cash-on-cash return). I had to look out-of-state for these kinds of opportunities. Cash-on-cash return is annual pre-tax cash flow divided by your initial investment.
Cash Flow = Rental Income – Operating Expenses – Debt Servicing Operating Expenses = Repairs/Maintenance, Improvements, HOA fees, Insurance, Property Management Fees, Insurance. I also build in a proxy for rental vacancy.
I tend to like for cash-on-cash (COC) returns with double-digits.
3. Tax Benefits
Buildings and houses don’t last forever. The IRS understands this and lets investors depreciate these assets over a number of years (27.5 years for residential real estate). This is a non-cash expense that can help shelter the investor’s taxable income. The investor could potentially have a positive cash-flowing investment that is operating at a loss for tax purposes, and that’s the shelter. Some investors purchase investments in areas that they like to travel to. Investors may travel to inspect their investment and perform business activities such as meet with property managers, contractors, and insurance representatives. The portion of the trip expenses related to business can potentially be a tax write-off. Other potential write-offs are home business deduction, cell phone expenses, and mileage. Consult with your tax accountant/CPA on these items first.
4. Equity Build-up through Loan Paydown
Purchasing real estate with with leverage (e.g., getting a mortgage) can increase you COC return and also provide equity growth. With each monthly mortgage payment, a portion goes to interest and a portion goes to pay down the principal of the loan. That principal paydown is reducing your loan, therefore increasing your equity in the investment. This benefit is often overlooked. A good way for investors to prove this out is the periodically calculate their net worth.
5. Inflation Hedging
Inflation is the devaluing of the dollar, cash in the bank is worth less and can’t buy as much as it used to. Real estate investing is considered an inflation hedge because home values and rents typically increase in times of inflation. On top of that, if there is mortgage on the property, this is great for the investor as the value of his/her indebtedness decreases!
There are many other great benefits such as investment portfolio diversification, high tangible asset value, and low maintenance (some beg to differ).