9 Reasons I Want to Invest in Real Estate, Part 1

9 Reasons I Want to Invest in Real Estate, Part 1

In my last post about financial goals for 2020 I talked a little bit about real estate investing.  One of our goals is to begin incorporating real estate into our investment portfolio.  I initially planned to write about all of the reasons I want to invest in real estate in a single post, but it started to get quite long. So, I have decided to break it up into two parts. We will discuss the first four reasons today.

There are many different forms of real estate investing which include flipping houses, buy and hold rental properties, wholesaling, REITs, syndications, crowdfunding, etc.  For the purpose of this blog post, however, let’s discuss real estate investing in the context of one of its simplest and most traditional forms: buy and hold rental properties.

This means you buy a property, hold it for the long term, and rent it out to a tenant.  Again, to keep things simple, lets assume this is a typical 2 to 4 bedroom home where one family lives (aka single family home).  

Our Scenario

Let’s create an example scenario of a single family home real estate investment for the purpose of discussion in this post.  Let’s assume you buy a 2 bedroom, 2 bathroom single family home for $100,000.  For simplicity, we’ll assume you paid cash for it to start.  

Based on your local market conditions you are able to rent the home for $1,000 per month.  This is the gross income that the property brings in per month.

Of course, there are costs associated with owning this home which include property taxes, home insurance, maintenance, lawn care, and snow removal.  You also include in your cost an allowance for vacancy (times when the property is not rented to a tenant), property management, and capital expenditures (higher expense items that may need to be fixed in the future (water heater, roof replacement, etc.).  These expenses total $500 per month.

If we take the gross income and subtract the expenses ($1,000 – $500) we are left with $500 each month.  This is called the net operating income of the property, or NOI for short (real estate investors LOVE acronyms).  Note that this does not include any debt payment on the property.  In this example, the property was purchased with cash, but IF it was financed, the monthly debt payment must be less than $500 per month in order for you to have positive cash flow.  If it is less, then you are in a negative cash flow situation, and that’s not so good.

Now, let’s discuss the 9 primary reasons I am so interested in real estate investing in the context of this simplistic example.

#1 Cash Flow

One of the primary reasons people want to invest in real estate, myself included, is cash flow.  This means that the investment produces a regular stream of income.  In our above example, you would receive $500 per month in net income (before taxes).  That’s $6,000 per year.  Not too shabby.  

Now imagine if you had 10 of these properties.  That would be $60,000 per year!  20 properties would be $120,000 per year!  You can begin to see the strategy many people use to create an income in retirement.  They accumulate a large number of rental properties and live off of the positive cash flow.  

Some people will say they want to invest in real estate because this cash flow is a good source of passive income.  Even though I don’t have any rental properties yet, I have learned enough about real estate to know that this is usually not the case.  I think this is a very important point to understand before investing in rental real estate. 

Of course there is a spectrum here.  If you own and manage the property yourself (including maintenance, rent collection, tenant acquisition, marketing, etc.) then this investment is anything but passive.  It’s really another job.  The positive is that you maintain the most control over your investment.  On the other end of the spectrum is having a property manager do everything, which makes this investment much more passive.  But as a result you sacrifice much of the control over your investment.  And you still have to manage the manager, so it’s never completely passive.  

#2 Leverage

I know what you’re probably thinking at this point: this is beyond my reach.  The above example is paying all cash for a house.  No way can I do that.  Well, that is why leverage is #2. 

What is leverage?  Well, in physics think of using a lever on a fulcrum to lift something heavier than you would be able to lift on your own.  It is a similar concept in real estate investing.  In simple terms, leverage means using borrowed money (debt) to purchase more than you would be able to purchase with your own money alone.  

In our above example, let’s say you didn’t have the $100,000 to pay cash for the house, as is the case for most people.  Instead, you go to a bank and apply for a mortgage.  If you pay 20% of the cost ($20,000), the bank agrees to pay for the other 80%, giving you an $80,000 mortgage.  You agree to a 30 year term at a fixed interest rate of 4.5%.  This gives you a monthly mortgage payment of $405, which could be covered by the net operating income of the property ($500) and still leave you with about $100 per month in positive cash flow.  Very doable.

By using leverage you were able to acquire the property for much less than its actual value and with much less money out of your pocket.  This is part of the magic of real estate investing.  While it is technically possible to use leverage for other investments, such as buying stock on margin (don’t do this!), using leverage to invest in this manner is generally limited to real estate investing.  

Leverage also allows you to invest in more properties than you would otherwise.  For argument’s sake, let’s say you did have $100,000 in cash.  If you purchased just the one home, we already established that after expenses you would be making $500 per month in positive cash flow, which is not too bad.  Over the course of a year, you would have $6000, which is a 6% cash on cash return on the $100,000 you invested.  

Now let’s pretend that instead of buying just the one home for $100,000, you purchase five separate homes worth $100,000 each, making a 20% down payment of $20,000 for each home.  Like above, we’ll assume your monthly mortgage payment for each home is ~$400, leaving you with a positive cash flow of ~$100 per home.  Interestingly, with five homes earning $100 per month, for a total of $500 per month and $6,000 per year, the cash on cash return for the $100,000 invested is also ~6%, which is the same as if you just bought the one house for cash.  

If the two examples have the same cash on cash return of 6%, why would I want to have the hassle and stress of five homes compared to owning one?  Good question. To understand the answer to that, we have to understand what is happening in the background here.  In this example of using leverage, your tenants are essentially paying down the mortgages on each of the properties with their rent checks which builds equity in each of the five homes for you.  At the same time, the homes are most likely going up in value, which is called appreciation, and it is better for you to have five homes going up in value compared to just one.  These are both concepts we will discuss next.

Before I end the discussion on leverage, it is important to also be aware of the risks involved in using leverage.  Everything is fine and dandy while you are collecting rent.  But what happens if the property becomes vacant for 6 months and you can’t find a tenant? Or what if there are major expenses like replacing the roof?  If you don’t have the cash reserves to pay for these situations, you are going to be in trouble.  If the property is leveraged, the monthly debt payment must be made or it will enter foreclosure.  Over-leveraging properties was a major contributor to the financial crisis in the 2008-2010 recession and many investors lost their properties or had to file for bankruptcy.  

#3 Equity

In simple terms, home equity is how much of the home value that you own.  

In our above example, if you purchased the $100,000 home with cash, assuming it is worth that amount, your home equity is $100,000, or 100% of the value of the home.  

If you financed the home with a 20% down payment of $20,000, then you still owe $80,000 on the mortgage.  Your home equity is calculated by taking the value of the home ($100,000) minus the amount you owe on the mortgage ($80,000), which is $20,000 or 20% of the value of the home.  As mortgage payments are made, some of the money is paid in interest to the lender, and some of the money is paid toward the principal (the amount that you borrowed).  As the principal is paid off, this increases your home equity, which again is how much of the home you own.  For example, if you paid off $10,000 of the principal, assuming the home was still valued at $100,000, you would now have $30,000 in home equity.  

Now here is some of the magic of real estate and home equity.  Most of us know that home values tend to go up with time.  This is not always the case, but generally over time the price appreciates (goes up) which we will discuss more below.  Let’s continue with the example in which you have paid off $10,000 of the principal, making a total of $30,000 you have paid toward the home, not including interest payments.   If the $100,000 home you purchased is now worth $150,000, you still only owe $70,000 on the mortgage.  Again, your home equity is calculated by taking the value of the home ($150,000) minus the amount you owe on the mortgage ($70,000), which is now $80,000.  So even though you have only paid $30,000 towards the home, not including interest paid to the lender, you now have $80,000 in home equity.  Pretty sweet, right.

This gets even better with rental real estate.  With our above example of five homes purchased with 20% down payments of $20,000 each, the monthly mortgage payment is about $400 per month, assuming a 30 year mortgage with a fixed interest rate of 4.5%.  The rent on each home per month is $1000, of which $500 goes towards expenses that, as discussed above, include property taxes, property management, insurance, maintenance, vacancy, future capital expenditures, etc.  The remaining $500 is then used to pay the mortgage payment, leaving ~$100 in positive cash flow per property.  Now remember, the mortgage payment pays interest to the lender but also pays down the principal of the loan.  This, in turn, builds your home equity in the property.

This example encapsulates one of the major advantages of using leverage for real estate investing with rental properties. What is essentially happening is your tenants are paying down your mortgages for you over time and you still make a little money each month. When the mortgages are completely paid off, you will make even more money each month in positive cash flow AND you will own five properties free and clear. 

#4 Appreciation

Now let’s discuss appreciation.  As mentioned above, appreciation is when the value goes up over time.  It is better to have appreciating assets rather than depreciating assets.  Stock values tend to go up over time, thus they are appreciating assets.  Likewise, real estate values tend to go up with time, making them appreciating assets.  Conversely, the value of automobiles goes down with time, making them depreciating assets.  See the difference?

Appreciation is great for real estate because it increases the amount of equity you have in the investment, as discussed above.

Here are three primary ways your real estate investments can appreciate in value:  

Appreciation When You Buy

You have probably heard the saying that you make money in real estate when you buy, not when you sell.  Let’s talk about why this is true.  

Real estate is an inefficient market.  This juxtaposed to the stock market, which is extremely efficient.  What does that mean?

In an efficient market, the value of the asset reflects all known information regarding that asset, and an asset’s price truly reflects its actual value.  Let’s take stocks as an example.  For a given stock all publicly available information is available via technology to literally millions of people.  This dictates the demand for the stock and thus its value and price.  This makes it very difficult to find an undervalued stock because it is such an efficient market.  

On the other hand, real estate prices are dictated by what price a single seller chooses to list a property at and what buyers agree to pay.  This often has little to do with the market at large.  Some sellers will ask too much for a property based on how much they feel a property is worth (as opposed to comparable properties in the area) or they are emotionally attached to the property.  At the other end of the spectrum some sellers will list properties well below market value based on a variety of circumstances.  These include changes in health, getting a new job in another area and having to move quickly, or someone that inherited the property and just wants to get cash for it as quickly as possible.  In these ways, real estate can be a very inefficient market.  

In an inefficient market, a savvy investor is able to find good deals to maximize profits.  Let’s say you are able to find a 2 bedroom 2 bathroom home for sale for $80,000.  You know that based on comparable homes in your area, the true value of the home is $100,000.  You purchase the property for the listed price and right away you have $20,000 more in home equity more than what you paid for the property.  This is an appreciation of the value, or perceived value, right when you buy the home.  And this is how you make money in real estate when you buy, not when you sell.  

Forced appreciation

This refers to changes you make to the property that increase its inherent value.  For example, let’s say you purchased a 2 bed 2 bath home for $100,000 with plans to convert an extra space into another bedroom.  You spend $10,000 on the project, converting this into a 3 bed 2 bath home.  Based on comparable 3 bed 2 bath properties in the area, the home is now valued at $120,000.  This improvement to the property causes forced appreciation, increasing your home equity by $20,000.  Subtracting the $10,000 cost of the project, this one improvement to the property has given you a net profit of $10,000.  

Appreciation Over Time

This is what most of us think about when we consider how home prices go up over time.  We’ve all heard stories of how someone purchased a home 30 years ago for $50,000 and now it’s worth $250,000, or something of that nature.  This is appreciation in the value based on the overall real estate market appreciation over time.  Appreciation over time is another way your real estate investment can return a profit.  

In most real estate markets, properties tend to appreciate by 3-5 % of the property value each year, keeping up with or slightly outpacing inflation. However, this is definitely not always a sure thing, at least in the shorter term.  There can be stagnations or downturns in the real estate market, and sometimes these can be quite significant as we saw in 2008-2010.  This is why most real estate investors would not recommend purchasing a property with the expectation that most of your profit will come from appreciation in the value over time, as this can be quite unpredictable.  

Conclusion

Real estate investing has many benefits that are not available in other asset classes.  Today we have reviewed four reasons I am very interested in adding real estate to our investment portfolio: cash flow, leverage, equity, and appreciation.  Next week we will discuss five more reasons I would like to invest in real estate.

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

If you enjoy this content, please support the blog by subscribing below (the only emails you will receive are my weekly posts).  You can also share this post through the links below to your social media accounts.  Both these actions increase the blog’s rankings in search engines, which helps me reach more people.  Thanks for your support.