What Many People Miss About Investment Real Estate

[Eric Fernwood]

Many people believe that the primary benefit of real estate investments is cash flow. While cash flow is certainly important and is a key factor in achieving financial independence, there are other benefits to investing in real estate that can be even more important.

The order in which you make the most money:

1. Appreciation
2. Tax benefits
3. Cash flow

Appreciation

Appreciation has the potential to generate much more profit than cash flow. For instance, let's compare the amount of after-tax investable cash generated after 5 years of appreciation versus 5 years of cash flow. To isolate the effects of cash flow and appreciation, I ignored factors such as inflation, rent increases, and other real-world costs and expenses.

As you can see, appreciation can generate significantly more profit than cash flow. Additionally, a refinance is not taxed. Our clients (and I) have used cash-out refinancing to reinvest accumulated equity and grow their portfolios with minimal capital investment over the years.

Tax Benefits

Every dollar you save in taxes has a 30% to 40% return, depending on your marginal tax rate. You can have positive cash flow while having a taxable loss. Below is an example. This enables you to shield other income, effectively increasing your cash flow and return.

Also, with the right tax strategy and involvement in the management of your properties, all losses can be deducted from regular income. This approach can greatly reduce your taxes.

In addition, there is a tax advantage unique to real estate known as the 1031 exchange. Essentially, a 1031 exchange allows you to sell an investment property and reinvest the proceeds in another investment property, deferring the capital gains taxes.

Real estate is also an excellent way to transfer wealth across generations. When a property is inherited, the basis is stepped up to the current market value, and depreciation starts anew. This can make your children's lives easier and give them a head start.

Cash Flow

Cash flow is what breaks you free from the daily grind of work. And, if you buy in a location where rents keep pace with inflation, your escape from the treadmill can be permanent.

Cash flow has other advantages:

• Accumulate cash for future down payments and to pay off the mortgage.
• Income reliability - Many purchases are optional. For example, no one has to take a vacation, buy a new car, or buy Apple stock. When times are tough, the market and all that goes with it take a hit. However, having a place to live is not optional. So, market stress tends to have little impact on rental income.
• Inflation hedge - Rents have historically kept pace with inflation. And, when there is economic distress, capital moves to hard assets like real estate driving up prices and rents.

Cash flow is like the golden eggs laid by a magical goose. However, the true value of investing in real estate lies in owning the magical goose itself.

[Joe Villeneuve]

The role of cash flow as you are building your portfolio, is to recover your costs ASAP.  Your cost is exclusive to the cash (only) you put into the deal.

Appreciations role is to grow equity and move, with "move" being the most important role of the appreciated equity.  It's the equity (frozen cash, and the actual cost of the property) that is the means to grow your portfolio.  As your equity grows, it loses value.  The equity is what you are paying for the property and the cash flow.  As the equity grows, dollar for dollar with the appreciation, it loses its buying power and is actually buying less and less property value and cash flow,...as long as it remains in the same property it is growing in.

This is where moving it (selling the property) maximizes the buying power of that equity.  Keep moving it as it grows in a property, and it will increase exponentially its buying power.