Real Estate Investor vs. Mortgage Lending?

Question

I am new to real estate investing and bought many books on how to buy, fix, rent, or flip them. I haven't made any deals yet. I was also considering mortgage lending as a career.

My question is ....which is more profitable? Becoming a mortgage lender and getting a license or buying and flipping houses? I heard mortgage lending is a tough business and turnover is high.

If I buy houses should I go through a real estate agent? I have an appt. with a dave ramsey specialist to buy my first home.

Need some advice.

Thanks,

Jack

Jered Sturm · Answer

I realize my message wont align with Dave Ramsey’s teachings but I also do not personally agree with them so I would like to show you an alternative. Also I know you mentioned flipping, but flipping can be very similar to lending so read below for some of my thoughts on which strategy I like best.

When it comes to real estate investment the two most powerful things are debt (leverage) and taxes. Typically you receive neither of those benefits when doing hard money lending that you mentioned.

Here is an example of two investment channels you mentioned:

Hardmoney lending:

$100k lent out for 1 year at 12% interest w/ 2 points will give you a gain of $14k or a pre taxCOC of 14%. Lets assume you are in a 35% tax bracket. You will cut a check to the IRS for $4,900, leaving you with $9,100 or a after tax cash on cash of 9.1%

Apartment building investment:

$100k down payment on a $500k building. At an 8% capitalization rate (very achievable) you are left with $40k net operating income. lets assume when you borrowed the $400k from the bank they lent it to you at 4% interest over a 25 year term. This means your year one mortgage payment is $25,332 ($15,827 interest, $9,505 Principle)  leaving you with $14,668 in cash flow or a pre tax cash on cash return of 14.6%. This beats your total pre tax return of 9.1% from theHMLabove BUT we haven't even started on all the other benefits of investing in real estate.

So you cash flowed $14,668 do you pay tax on $14,668?? NO! Another beauty of real estate and leverage is the depreciation tax benefit. Even though you only put 20% of the $500k in to the property you get ALL of the depreciation. Apartment buildings/houses are depreciated over 27.5 years, which means you get to depreciate the building value. The buildings value does not equal the property value because the building sits on land and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value to allocate to land value is 20%, or in this example it would be $100k. This leaves you with 400k of building value to be depreciated $400k/27.5=$14,545. What does this mean? It means you barely pay any tax on that $14,668 cash flow you made on the building. You actually only have a taxable gain of $9,628 ($14,668 + $9,505 - $14,545) we add back the principle amount of your mortgage payment because it is not deductible and subtract out the deprecation we listed above. Again assuming a 35% tax bracket the gain of $9,628 would result in cutting a check for $3,370 to the IRS. This means your after tax return is 11.3%. A 2.2% increase on after tax return when compared to hard money lending

That’s all great and will make you a lot of money, but HML has no tenants, no phone calls, no toilets. That piece of mind in its self is worth not receiving the additional 2.2% return owning real estate provides right? I don’t think so because there is one more major piece to this puzzle.

Another huge difference betweenHMLand owning investment real estate is the power of debt and with debt comes amortization. Wealth is built  in the amortization of the debt you put on the property. Back to our example the $400k in debt you put on the building will have an army of tenants paying down your mortgage month after month. In our example after 10 years you will only owe $285K on the building IF the property never appreciated one cent and it was still worth $500k in 10 years you would have $215K in equity. You could then sell it or refinance it (again tax free).

Now lets wrap the amortization into our example. Using the loan terms I mentioned the first years of the loan will result in a $9,505 reduction in principle or if the value stays the same that would be seen as a $9,505 increase in equity. If we add that $9,505 to the cash flow and tax benefits we are left with an all inclusive after tax return of 20.8%.

This is just the basics. You can accelerate depreciation benefits through cost segregation, Structure loans for quicker amortization depending on your goals and many other tricks.

I realize this is very different from Dave Ramsey but I thought I would at least put it out there for you and others to read.

I hope this helps!

Boris Grinberg · Answer

thank you @Jered Sturm.

As a lender, my upside is limited to 10% per year. My borrowers have a cap rate of 5-10% depending on location, but 10% property price appreciation gets them 25-40% increase in equity profit (because of leverage via mortgage/loan).

I make a sensible profit in lending, but this is not a long term passive income creation. These loans are 6-12 months so there is no long term play.

As such, I do both, lend money and own real estate. Lending pays my bills but real estate is building my nest..

Katy Oh · Answer

Jared, that's awesome. Still trying desperately to grasp it. I get it (sort of) but wondering if I will apply the knowledge once I'm ready to proceed. OH YES ....I will!!.... eventually!

Thank you!

David Dachtera · Answer

@Jack Hensy,

About all I can offer is that lenders are considered the wealthiest people on the planet.

Why?

Lotta cash return, no physical property holdings (until they have to foreclose). Study up on "arbitrage" also.

My $0.02...

David J Dachtera

Boris Grinberg · Answer

@Jered Sturm. I am not tax expert, but i thought that if you use depreciation, you just build an equity in your investment property. If you sell the property at some point, wouldnt you have to pay tax on capital gain that increased by the amount of the cumulative depreciation? I was told the difference is really how one is being taxed as ordinary income vs capital gains.

Todd Hensy · Answer

Jered brilliant analysis. The things you pointed addressed all my questions. Even though I love real estate and its interesting to drive around, find them, fix them and rent them( at least from a book perspective)---it seems like back breaking work and a lot of headaches with tenant issues and laws.

I have heard horror stories from tenants who trash the place despite airtight rental agreements or fixing a toilet at 2am. I should start out with a house and rent out the other rooms that way I live there with the roommates and I can monitor things closely as a landlord.

Apartment complexes are WAY OVER my head, but nonetheless a great example. I am a beginner and would go nuts managing an apartment complex unless I got a property management company to do it for me -- which is another expense.  I have some handy many skills. But I get that you used the apartment complex as an illustration. This would also apply to homes, condos, townhomes, duplexes, and small fixer uppers.

In term of being a mortgage lender I find it fascinating as well to write up contracts and use my sales/customer service ability to assist others. I know its high stress, but less back breaking work and more of a mental grind which appeals to me more. I can handle tough mental tasks, better than the physical ones.  I will pursue both--buy a house, live in it and rent out the extra rooms. Then I will pursue mortgage lender.

Jered Sturm · Answer

@Boris Grin I am no tax expert either. All I wrote above is simply picked up through my own investing experience. In regard to your question, I believe you are correct and the term for this is commonly know as depreciation recapture. HOWEVER our ever so generous government incentives real estate investing in so many way they even give us a way to avoid depreciation recapture! This is called a 1031 exchange. I have never completed a 1031 myself but my understanding is all of the gains you would realize in the sale of property (including depreciation recapture) can be rolled into the next property you purchase. You can do this unlimited amount of times, and when you die all those built up gains you have sheltered through 1031s just disappear. When you die the tax burden dies with you. Just another great gift from our IRS to incentives real estate investing.

There are a ton of rules on 1031 exchanges  so dig into them if you're thinking of utilizing them.

@Katy Oh If you're just beginning and "sort of" grasping all those moving parts then you're ahead of the game! the key is too pick up the very basics terms... Cashflow, NOI, Debt service, etc. This way you can begin to build on those and eventually see the whole picture of investing including taxes, amortization and all the other crazy moving parts. If you're on BP and reading it wont take you long!

Real Estate Investor vs. Mortgage Lending?

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