Several articles claim that 80% of the world’s millionaires create their wealth through real estate.
Is this “fact” or “fiction”?
Truthfully, I’m not sure…
I have not personally been able to find any studies that can prove this massive claim, however, I would not be surprised if this were accurate.
Real estate can be a great way to build wealth for many reasons.
There is a clever acronym (I.D.E.A.L.) used to demonstrate why real estate can be a great investment and wealth building tool… so long as it is done PROPERLY (notice the emphasis on “properly”).
The acronym “I.D.E.A.L.” stands for:
Let’s take a look at each one individually and figure out why they are important and how they can help explode your wealth.
Income is what makes real estate so unique. It is also why I love rental real estate.
Unlike stocks, bonds, and CD’s… real estate (if purchased correctly) typically will generate a much higher income. See below for a couple examples:
- Stocks: No income or possibly a small 1-2% annual dividend. Stocks are mostly an appreciation play.
- Bonds: As of this post, the 10yr Treasury Bond is at 2.731% and 30yr Treasury Bond is at 3.064%. Bonds produce a better yield than stocks but usually have limited appreciation.
- Certificates of deposit (CD’s): According to BankRate as of today (1.10.19), Capital One is currently offering a 1yr CD w/ a 2.7% annual yield. CD’s produce a yield on your original principal, however, the original principal balance does not fluctuate (no appreciation).
- Real Estate (if purchased correctly): Can often yield between 6-10% annually with no mortgage.
Would you prefer a 2.7% Certificate of deposit, or a 6% yield with real estate?
And, oh by the way…
You can earn a much higher yield on real estate when you use debt strategically and responsibly (i.e. mortgage / leverage – more on this later).
* Important to note – real estate can come with additional risk (i.e. tenants, repairs, management, etc.). So, it is important to build these expenses into your analysis before you purchase a rental/investment property – more on this with a later post.
Real estate investing comes with some very powerful tax advantages. One of which is Depreciation.
Depreciation is essentially a “phantom” expense that the IRS allows you to take as a deduction against the building value (not land) over a 27.5 year period for residential property (27.5 years is what the IRS considers to be the useful life).
FYI – “Phantom” expense refers to an expense that you can legally deduct but you don’t pay out of pocket for…. Pretty cool right?
Here’s an example from ZILLOW:
Let’s say you buy a single-family home for $200,000. The tax assessor’s estimate of the land value is $75,000, and the building value estimate is $125,000. Your depreciation expense that you take each year against rental income would be $125,000 divided by the IRS allowed 27.5 years of useful life (residential real estate) for a depreciation expense each year of $4,545.
Based on the example above, your rental property would provide you with a $4,545 depreciation expense that you can use to help reduce your taxes.
Imagine if you acquired 4 similar properties over a 10 year period (very achievable)…
With 4 similar properties, you would now have $18,180 in depreciation. If you have a marginal tax rate of 24%, that would save you $4,363.20 in taxes ($18,180 x .24 (tax rate) = $4,363.20). This can really start adding up.
*** Please note – check with you CPA for any tax related questions – depreciation works differently with various income levels.
Equity is the difference between what you owe on a property and what it’s worth.
Let’s say you have a $160,000 mortgage on your rental property and the home is currently valued at $200,000. In this scenario, you would have $40,000 in equity ($200k value – $160k loan = $40k equity).
Assuming you have a fixed rate fully amortized mortgage (where you pay principal and interest each month) on your rental property; with each payment you make, the loan balance goes down (further building your equity).
Now let me ask you this…
Wouldn’t it be nice to have your tenants working hard to help you build your equity?
Well, with the income you generate from your rental property, this is exactly what happens.
Each month the rental income comes in, and then you use it to cover operating expenses and debt service (AKA mortgage). In turn, your loan slowly gets paid down, and your equity increases… thus adding to your net worth 🙂
Appreciation is the icing on the cake in rental real estate. It occurs when your property becomes worth more money than when you originally purchased it.
So, when and how does this occur?
Well, this is kind of a loaded question because appreciation is never guaranteed, however…
Appreciation can occur in 3 ways:
– Organically – Your property can go up in value based on factors such as being in a strong economy, redevelopment area, strong job creation, commercial infill projects, etc. Think – LOCATION, LOCATION, LOCATION. This typically takes a substantial amount of time (several years).
– Forced – Forced appreciation occurs when you renovate your property (i.e. add a bedroom / bathroom, add square footage, improve/add parking spaces, etc).
Additionally, if you can find unique ways to increase income or decrease expenses, your property value will go up. This can be accomplished in a shorter period of time with a solid game plan.
– Inflation – Inflation (asset prices increasing) essentially occurs when the money supply in circulation increases at a faster rate than the economy can grow. This makes the dollar worth “less” than it was when you first purchased the rental home and in turn, it drives the prices higher.
Think back to the price of eating out 10yrs ago… It may have cost you $50 for a date night with your wife or husband (dinner and a movie). Fast forward to today, easily $80 because of inflation. Inflation can take several years, but with real estate, it’s important to remember that inflation is working to your benefit.
Appreciation is great, but you want to avoid purchasing based on speculation. Always remember to purchase rental real estate that cash flows starting on day one. Or… At minimum, have a plan to achieve adequate cash flow within a short period of time (less than 6 months). This will help reduce risk and ensure you can weather the storm in case the market cycles unfavorably.
Leverage (AKA debt, AKA mortgage), can be one of the best tools in real estate. It allows you to purchase a property without having all of the cash needed to cover the entire purchase.
Here’s an example of leverage:
Let’s say you want to buy a $300,000 duplex in Sacramento, CA. You are buying this strictly as a rental property, but you don’t have $300k sitting in your bank account to cover the entire purchase.
What can you do?
Well, you can go to your local mortgage broker and apply for a loan. Since it is strictly a rental property (you have no intention on living there), the lender will require a 20% down payment which would be $60,000 ($300k price x 20% down payment = $60k).
So in this case, the bank is saying, if you bring $60,000 to the table (20% of purchase price), they are willing to loan you the remaining $240,000 (80% of purchase price) to buy your rental property.
Essentially, the bank is willing to be your partner on deal. This is a HUGE win for you. Now you can start building wealth today as opposed to saving the entire amount needed to pay cash for the property.
*Check with a mortgage broker for the requirements and guidelines pertaining to securing financing*
The best part about leverage…
The income generated from your tenants can pay down your mortgage, help you build equity, and increase your net worth.
* Full disclosure – debt can be very dangerous. Make sure you are weighing the pros/cons and talking with your CPA/financial advisor before taking on large amounts of leverage as you build your real estate portfolio.
Can you picture yourself as a real estate investor?
As you can see, there are several benefits of owning rental real estate.
However, it is not for everyone…
Real estate usually requires a big upfront investment of time, energy, and effort to properly purchase and manage rentals effectively. Additionally, it helps if you have some money saved for emergencies, down payments, repairs, etc. I have found that random things tend to pop up in real estate, so it is always better to be over prepared whenever possible.
If you’re willing to put in the work… you can reap the rewards that come from income, depreciation, equity, appreciation, and leverage.
Is real estate I.D.E.A.L. for you?
Hope you enjoyed the post and found it useful.
All the best!
Want to buy, sell, or invest in real estate?
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We cover Sacramento & Placer County in California with a special focus on Roseville, Rocklin, Loomis, Penryn, Lincoln, Newcastle, Orangevale, & North Natomas (Sacramento).