While the oft-stated statistic that 90% of the millionaires in this country were produced by real estate investing is unverifiable, real estate is still one of the most common paths to wealth creation and accumulation for investors. Because it traditionally takes time to build up capital for real estate investment and because real estate projects generally have long-term horizons, it is more of a “get rich slow” than “get rich quick” type of investment.
Cash Flow and Appreciation
Investing in real estate can be a powerful wealth builder because it offers both potential cash flow and appreciation, and generally does so at a relatively low level of risk. While some types of real estate investing come with more risk (fix-and-flips, for example), it is generally a safe, stable asset class to invest in.
With residential real estate, the investment generally takes the form of a single-family rental house or a multifamily rental building. The idea is that the rental income produces a predictable and steady cash flow, while the underlying asset grows in value due to both micro and macroeconomic factors. Certain types of investments, particularly depending on the location, can be more heavily weighted towards either cash flow or appreciation. There are many different ways to invest, from house hacking, fix-and-flips (buying a house, renovating it and then selling), purchasing rental properties (short-term, long-term, vacation houses and more) and now, investing in opportunities on crowdfunding platforms.
Traditionally, in order to invest in any kind of income-generating rental property, an investor needs to have capital for the down payment. For rental properties, that is usually 25% of the purchase price at minimum with the rest of the purchase price covered by a mortgage. That can often be a high barrier to entry, but with crowdfunding platforms, investors can get access to many different types of real estate investments at significantly lower entry prices.
Leverage boosts potential returns
Because of the sheer size and scope of the real estate market, it is difficult to truly compare its historical returns to other asset classes and you can find a lot of statistics that show that home prices do not grow at the same rate long term as the equity markets. However, that does not mean rates of return in real estate investments do not approach or exceed those in other asset classes - the key difference is leverage. Investors in real estate often borrow a large percentage of the funds necessary to purchase a property. In doing so, they capture all of the appreciation at a much lower initial cost. For example, even if a property only appreciates at a 5% rate, because the investor owns all of those gains, if they made a 25% down payment, that is effectively a 20% appreciation rate (5% divided by 25%).
If there is financing in a deal, the key elements to look for are the length of the loan term (which often determines when a property will be sold), the interest rate (the rate itself and whether it is fixed/variable) and the LTV (“loan-to-value” meaning the size of the loan compared to the value of the underlying property). A high LTV means a bigger loan which generally means a higher upside but more risk, a lower LTV generally means a lower upside and less risk.
Consider a typical situation where an investor buys an investment property with a mortgage. If that property shows positive cash flows after mortgage payments, essentially the investor is getting their renters to pay off their mortgage while the asset grows in value. Additionally, mortgage payments tend to stay the same while rents continue to rise. As the investor owns the property for longer, more of their mortgage payment goes towards paying off the principal and not the interest. Even before considering potential appreciation or the positive cash flow, in paying off a 30 year mortgage that had a 25% down payment, an investor quadruples their investment in that time period by owning the asset outright.
Now, consider that properties tend to increase in value over time, and cash flows increase over time and the potential for wealth creation in real estate investing becomes apparent. Not to mention that there are a number of tax incentives to owning investment property that vary based on an individual’s tax situation. While rental income is taxed the same as any kind of income, there are a number of deductions that can be used to offset that income and investment property can be depreciated as well. Upon sale, if the property is held for over a year, the profits are taxed as capital gains, which is generally a lower rate than income. There are also 1031 exchanges that allow taxes to be deferred if the proceeds are invested in like-kind properties - essentially, you can use proceeds from the sale of one investment property to buy another investment property without paying taxes on the profits. There are entire guides to tax benefits and 1031 exchanges that are worth reading to see how they apply to your individual situation.
Here is an example that shows how powerful investing real estate can be, even with conservative projections. This is based on a $750,000 mortgage (with 10% of the down payment, $25,000, in closing costs) with a 30-year fixed 3.8% rate:
A modest 3% cash-on-cash gain and 3% appreciation rate still returns over an 18% ROI in year 1, and as rents and expenses increase but the mortgage stays fixed, the ROI grows to nearly 30% by year 10. Now consider that most investors look for higher than 3% cash on cash returns and the average appreciation rate in places like San Francisco (7.2% over the past 10 years) and Brooklyn (6.52% over the past ten years) significantly outpace the 3% example rate.
Conclusion
Investing in real estate generally is a longer-term play that usually does not offer much opportunity for liquidity. It is best suited for patient investors who can afford to tie up capital and potentially sacrifice short-term gains for longer-term returns.
