Real estate is all about asymmetric risk and reward. When the government gives you subsidies in the form of mortgage interest tax deductions, a $250K/$500K tax-free profit, and bailouts for overextended homeowners over and over again, you’d be silly not to invest in real estate! When you can invest lots of other people’s money and not have to split the proceeds if you make a killing, that’s a wonderful thing!
There’s a reason why every rich person you know owns multiple properties. There’s a reason why enormous fortunes have been made through real estate as well. How can President Donald Trump still be a billionaire after declaring bankruptcy? Asymmetric risk and reward.
It’s no wonder property owners were once called lords, or now more colloquially, landlords. The wealthy own assets, while the not-so-wealthy lease assets. After 30 years of paying $2,000 a month in rent, your return on $720,000 is negative 100%. At least through a mortgage you’ve got an asset which you can live in rent free or pass on to your children once paid off. You might not make money as the downturn has certainly shown, but at least you have a chance.
When it comes to making money, if there is no risk, there is very little reward. The biggest reason for the widening wealth gap is due to the ownership and lack of ownership in real estate.
EXAMPLE: BUILDING $400,000 THROUGH ONE PROPERTY
In early 2003, I put down 20% on a $580,000 condo with a mortgage payment of roughly $2,400 a month at 5.75%. I had just turned 26 and was nervous but adamant I didn’t want to pay more than $2,000 a month on rent. The $464,000 mortgage payment was split $500 to principal and $1,900 to interest. Rent for a comparable property at the time was $2,000 a month, so things were essentially a wash if you include property taxes and deductions.
In 2013, the mortgage rate was 3.375% thanks to several refinances on a loan of $285,000 (from $464,000). I’ve painlessly paid down $180,000 (39% of entire loan) in principal through my PMI loan and the occasional ad hoc principal payments. The mortgage fell to just $1,300 with $500 of it going towards principal. Meanwhile, I was renting the place out for $3,400 a month!
Mortgage interest not only dropped from $1,900 to $800 (-58%) during this time, rent went up from $2,000 to $3,400 (+70%). There are several reasons for this phenomena: 1) Supply is tight in San Francisco due to building restrictions on our 7 mile by 7 mile city, 2) Demand continues to rise due to an increase in jobs from new startups, 3) The economic crisis caused bonds to rise and yields to fall, and 4) The Federal Reserve continues to conduct very loose monetary policy. If you’ve ever deliberated between good location and higher prices or bad location and lower prices, consider the former.
Today, the mortgage is zero because I finally paid the sucker off in 2015 after receiving an influx of cash. I’m now charging $4,200 a month in rent in 2017 while collecting roughly $3,000 a month in net cash flow after HOA, taxes and maintenance.
My $116,100 downpayment has turned into a cool $1,000,000 fourteen years later with very little work on my part. For twelve years, my tenants helped pay down my principal. All I had to do was find good tenants about once every two to three years. If I want to sell the property, I can without having to pay any long term capital gains tax due to the 1031 Exchange system which lets me defer or never pay taxes if I find a similar income property within 180 days of sale. Talk about pro government housing!
More Reasons Why Real Estate Is A Great Asset
* Hedge against inflation. You only hate inflation if you don’t have an asset that is inflating. If you own an oil field, a private university, and organic farm, a gold mine, or a rental property, you are loving inflation! Inflation is increasing the prices of your goods hopefully faster than the input costs and the costs to operate your asset. You think rents and prices are expensive now, but I promise you they’ll look cheap 10 years from now.
* A money making play on inflation. Forget about protecting yourself against inflation. Owning real estate is a play on making money with inflation. If there so happens to be hyperinflation, your cash is devaluing rapidly as your real assets start surging in nominal value. Economic tightness will return sooner or later, causing another surge in property and rental prices. Related: Should I Buy real Estate In A Rising Interest Rate Environment?
* Generational wealth transfer. You can pass on property from generation to generation, conceivably making their lives a little bit better. Think about all the college graduates nowadays who are complaining they will never be able to afford a home like their parents due to exorbitant prices. Now think how much worse it will be for their children. If your parents happen to just give you one of their properties, life becomes much less stressful as you don’t need to pay rent anymore! You don’t have to study as hard to succeed either. You can pursue un-lucrative fields such as music, dance, and other fine arts if you so choose because those are your dreams.
* Little effort to build wealth. The most effort comes from researching the property you want to buy and finding the right tenants to pay your mortgage. Once you’ve run various scenario analysis and screened your applicants, you can basically set it and forget it. My average tenant turnover is 2.5 years. I host two open houses for 1.5 hours each, spend another two hours reviewing applicants, and another hour coordinating the move in and that’s it. Meanwhile, to turn $116,000 into $1,000,000 through equity investing is no easy feat, neither is saving another $884,000 over 14 years. The whole idea is to invest in assets that work for you, and not the other way around.
* Tax-free profits. The first $250,000 in profits for singles and $500,000 for couples is tax free if you live in your property for the last two years before sale! If you so happen to be in the top income tax bracket, this is absolutely music to your ears! In order to bank $250,000 in after-tax profits as a top income tax bracket earner, you’ve got to make around $450,000 in gross profits. This special feature alone makes me want to buy property over and over again.
* Serves a utility function. Unlike cash, which serves no utility function, property addresses a fundamental human need, shelter. If our financial system goes to hell, at least you will have a tangible asset you can actually utilize. The only thing I can do with cash is make paper airplanes and perhaps start a fire.
* Semi-passive income generation. Not only do you get to benefit from rising principal values due to inflation, job growth, and income growth, you get to also benefit from rising rents due to the same reasons! I first started renting my rental condo out for $2,300 back in 2005. Now I’m charging $4,200 a month for rent going into 2018. That’s a 83% increase in rent while my mortgage payments stayed the same or declined. You can also potentially earn healthy returns (8% – 15%) that are 100% passive through real estate crowdfunding and owning public REITs. I’m all about taking advantage of real estate crowdfunding to invest in the heartland of America where valuations are lower and yields are higher.
* Almost dummy proof. There were a lot of people who didn’t understand the terms of their loans (neg am, balloon payments etc) or who borrowed way more than four times their income with no savings buffer. Good thing for you, you’re no dummy because you’re reading this article and other articles about real estate investing. Once you run the realistic cost and revenue numbers based on data provided by the seller and comparable properties, you have a base case assumption. If you are achieving a rental yield of 7% and can borrow at just 3.5% after a downturn, your month should be salivating for such a 3.5% immediate spread with principal appreciation potential.
* Measurable wealth. I know that after I finish paying off a mortgage, my net worth will equal the market value of the property. When you invest in private equity, or even public equity, you are taking a massive leap off faith that management and other exogenous variables don’t crush your returns. You pretty much know what you’re going to get in real estate if you follow the course.
* Priceless feeling. There’s something nobody really tells you when you finally purchase your own home. Perhaps because that something is unquantifiable. Even though you likely won’t own the house outright in the beginning, it feels wonderful not to pay someone else’s mortgage anymore. It’s an amazing feeling to be the king or queen of your own castle where you can do what you please. So long as you pay your mortgage, nobody will ever be able to kick you out. You grow roots and finally gain conviction to launch your life.
RINSE, REPEAT, AND GET WEALTHY SLOWLY
I didn’t buy my house with the primary hopes of creating more wealth. I bought my house because I didn’t want to live in a crappy apartment anymore. Here’s my housing expense history if you’re interested with a housing expense framework to help keep your finances in order.
I wanted my own deck, backyard, and freedom to turn up the home theatre system as loud as I wanted. At the age of 28, I wanted to start living a better life after slaving away in the office for the past six years. If I wanted to make more money through real estate, I would have bought a multi-unit building instead. Life can’t all be about making money. Funny how we like to justify our purchases.
Despite economic Armageddon, real estate is still my favorite asset class. For those who are under water, don’t give up hope because everything eventually comes back. Very few other assets require so little work and allow for so much outside funding to create so much value over time. For those who don’t have the downpayment, don’t know whether you plan to live in one city for more than five years, or don’t want to go through the hassle of managing tenants, consider real estate crowdsourcing. I’ve personally invested $260,000 through RealtyShares in order to gain more exposure to the heartland of America where valuations are lower, and yields are higher than coastal city property. The older I get, the more passive I want my income to be.
Renting has its benefits, namely flexibility. But renting itself does not build any wealth. If you are considering investing your money that’s sitting in low yielding accounts, consider investing in real estate. It may be a tough slog the first two years, but in ten years, you’ll probably wish you had bought more!
Surgically invest in real estate: If you don’t want to constantly pay massive property taxes, don’t have the downpayment to buy property, or don’t want to tie up your liquidity in physical real estate, take a look at RealtyShares, one of the largest real estate crowdsourcing companies today. You can invest in deals around the country for as little as $5,000. It’s free to explore the various commercial and residential properties on their platform.
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. Interest rates have finally started to tick higher post election.
Updated for 2017 and beyond.