How Investors Build Wealth in Real Estate

[Andreas Mueller]

To provide for our future and our families, we invest.

Investing is different than other moneymaking activities. It means each dollar we’ve allocated is working overtime on our behalf, not just sitting idle in an account as inflation saps it of its power. Investing means our dollars are like little worker bees, earning us $ when we’re at work, at the park, with our kids, on vacation and yes, even while we’re asleep.

This could mean buying stocks, bonds, real estate, contributing to one’s 401k, hiring a financial advisor (I hope not), fine art, crypto, collectables, classic cars, or investing in someone else’s fund, to name most.

I chose real estate (w/ some stocks and crypto too).

It’s used by the wealthy, the middle class, the young, the old and yes even the broke (I was both the latter, and I’ll tell you how).

It pays robust, consistent returns, but it’s more involved and time consuming than just clicking a buy button.

Real estate investors get paid for doing the work.

Real estate is a familiar to us but we may not know exactly how to do it. Roughly 65% of Americans own a home, while 60% own stocks. Heck, we’ve all likely had a nosey landlord at some point in our life. But owning a home where you live is not an investment. It’s not an asset; it’s a liability. You have to rent the property to others (aka put it into service) to reap the many gains of investing. And only 6.7% of Americans own rental property, according to IRS fillings. Moreover, while we’re on the topic, most all rental properties are owned by individuals or mom-and-pop businesses, not Wall Street. They own less than 3%. In this vein, real estate investors are really small business owners.

This is the Way These are the 5 Ways:

How Investors Make Money in Real Estate

Real estate pundits and online gurus often overly focus on one aspect of this business: cash flow. That’s a very limited view, and frankly, leaves out the juicy parts. After all, a roasted bird is so much more than just the white meat.

In fact, there are 5 primary ways investors make money in real estate. Cash flow is just one of them, and it begins as one of the smallest (keep reading).

To be clear, cash flow is important (or rather it becomes important), but it is not everything. Not even close. We don’t get into real estate for a dividend check. Returns from real estate are much more lucrative than that.

Hopefully, this article will reframe your perspective on wealth and why many investors choose to allocate a large portion of their wealth-building operation to real estate.

Let’s get into it.

(* Quick disclaimer, for the purposes of this article, this writer is referring to residential real estate: 1-4 unit residences. The scale / analysis does change for commercial real estate because of vastly different financing arrangements, and buyer/seller marketplace expectations etc... So we’ll save that for another day).

#1 - Natural Appreciation

“Buy low sell high,” I’m sure most of you have heard the well-known adage. We invest in something we are confident will be more valuable in the future.

That’s appreciation in a nutshell.

The savvy investor must hone their senses and utilize the data to take advantage of an asset’s natural value/price appreciation. Natural means you don’t directly control it, but you can guide it. For instance, I am currently concentrating my investments in Nashville, TN. A city I have witnessed growing its population, # of businesses and GDP faster than the national average, while also maintaining a low unemployment rate and robust job creation. Further, within this city, I have learned the desirable areas to live, researched future developments, paid attention to criminal activity and researched the % historic change in property valuations. I have polled the barista, waiter and entrepreneur. I understand now where the path of growth is for the city and where real estate is likely to appreciate more than others.

The path of growth guides property appreciation.

This is how I prime my investment for success. It’s not a blind bet; but, it’s also not guaranteed. That is why investors get paid. We have to take risk, calculated risk, but risk nonetheless. The difference is, investors act when the odds are in their favor and if so, statistically over time, they will be successful.

As the late great Charlie Munger put it:

“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

— Charlie Munger

Remember, life isn’t baseball. You don’t have to swing. Munger’s business partner, this guy named Warren Buffett, is fond of saying:

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.”

— Warren Buffett

The dichotomy illustrated above is that both patience and initiative are equally important qualities in the character of any successful investor.

Take heed.

To be clear, we don’t bet on appreciation per-say. Investors don’t gamble. We make decisions that will give us a high likelihood for success and take action. In a way, investors get paid for their shrewd judgement.

Real estate, like any investment, can decline in value. Munger emphasizes that if you can't tolerate a potential drop in your investment value, you're “likely to only achieve mediocre returns,” as great investments can experience significant short-term price fluctuations. Investors have to be able to stomach volatility. In fact, you should probably assume it will happen. Fortunately, real estate is known for being extremely consistent and declines in value are rare and short-lived. If an investor reacted to every little bump they would miss out on the tremendous long-term returns. Prices are like the weather (not the climate), they fluctuate.

Case-Shiller National Home Price Index, Historical

And remember the above index is the average natural appreciation for the US. We endeavor to do better by picking a growth market/city, micro-targeting within that city and making sure we are in the path of growth.

Appreciation is how the majority of wealth/value is built in a real estate investment.

Not cash flow.

Remember this when calculating the total return on investment (ROI) in real estate.

The Leverage Effect

Real estate is often purchased with a loan to cover the majority of the asset’s cost. For example, the typical investor loan requires a down payment of 25% of the total property cost. This is called leverage. And in this case, the leverage is 4 to 1.

Using leverage enables you to drastically improve your ROI. Let's say you purchase a property for $500,000 and it appreciates to $700,000, the investment has made a 40% return.

Not bad.

But you used leverage in the form of a loan from a bank, not all cash. Since you put down just 25% of $500,000 - or $125,000 - and the property appreciated $200,000 - you made 62.5% on the dollars you invested.

Even better.

Real estate in the US is often purchased with leverage for this reason, and also because it’s one of the easiest assets to get a loan for (because of government incentives / regulation, which I won’t get into here). The lending terms and interest rates for leverage in US real estate are extraordinary. Real estate often has the lowest relative interest rate when compared to most other types of consumer-facing loans.

We often take this for granted as Americans. In fact, the 30-year mortgage with a fixed interest rate is a distinctly American benefit. Most other countries do not have this. Not Canada, not he UK, not Japan…

Take advantage.

#2 - Principle Paydown (aka Cash Later)

Another facet of using leverage, in addition to multiplying your investment’s return, is that you have to pay the mortgage back.

Crap!

But wait, this is actually a feature, not a flaw. Because it’s not the investor who is paying the mortgage, the debt is paid with the revenue the asset generates, in this case, the gross rents collected. Remember, a loan is broken into two parts: interest and principal, or the balance of the amount borrowed. Thus, every time the monthly mortgage is paid, the balance of the amount owed on that loan ticks down, and the equity value the investor owns ticks up (equity = assets - liabilities). And after 30-years (or whatever the term is on your loan) the balance is zero and the investor owns the entire asset outright.

Yay!

I think of principal paydown much as I do cash flow. But instead of that income being deposited into my checking account for immediate use, it is deposited in my property’s account for later use (or that I can borrow on now, more on that later).

Aka cash later. And it gets better.

At the start, the fraction of the mortgage that is principal is quite small. Typically just 1% annualized. The majority of the monthly payment goes towards the interest of the loan. So you aren’t putting much of a dent in the balance of the loan each month. But, in years 3, 5, 10… a larger, and larger, and larger portion goes towards paying down the principal and paying into your equity, particularly because of the way a loan is amortized, aka the process of writing down the value of a loan. This 1% quickly becomes 3%, then 5%, then 15%…

Cash later is very underrated in calculating real estate investment returns.

#3 - Forced Appreciation

Similar to natural appreciation, forced appreciation is increasing the value of an asset, but you control and can closely estimate it. We force appreciation when we add value to a property. In residential real estate, this is typically done via a renovation. But we can also improve the value of a property by fixing broken processes, removing bad management, working with the city to improve neighborhood blight, convincing a neighbor to stop parking their cars on the front lawn and clean up trash (yes, I’ve done this and wow what a difference in my property value :) etc…

Let’s focus on renovations, since it’s easiest to control and calculate. As a rule, I want a minimum 50% return on my construction dollar when I’m renovating a property. That means, if I spend $100,000 on renovations, I want the property to be worth at least $150,000 more afterward, if I were to put it on the market or want to refinance it. This means, typically, the larger the renovation the better, as long as I’m spending money judiciously. No gold bathtubs, we aren’t renovating the Taj Mahal. Deciding on a scope of work and what to spend money on is a skill that investors must hone.

Fortunately, we can calculate with high accuracy what our returns will be on a particular renovation. To do this we need to:

• Get quotes from contractors, and pick one;
• Add that cost to the price we paid for the property;
• Determine what price similarly renovated properties have recently sold for (we call this the ARV or after repair value). You can use Zillow to estimate this, or ask your real estate broker, which I recommend, as they likely have access to more data than you;
• Subtract the price of the home and renovation cost from the ARV to get our forced appreciation equity return. Voila!

For example: let's say we buy a home for $500,000 and put $100,000 into it. Based on the median ARV for sold comparable properties, we estimate it to be worth $675,000. Our total forced appreciation is $175,000, including $75,000 in equity returns. In other words, spending $100,000 to improve our asset made us $75,000 in equity or a 57.14% return on our construction dollars.

Nice.

You should also calculate this as a total leveraged return for the whole asset, like we did above, since we likely got a loan to purchase the property (and may have done so for the construction too, but i’ll assume not here). In this case, if we put 25% down ($125k) and paid for the renovation in cash ($100k) and the renovation returned $175k in forced appreciation, including a $75k equity return, this renovation brought us a 33% total return ($75k/$225k)!

I don't know where else you can confidently get a 50% value add return or a 33% total return. And the ROI is even better if you get the property for a great price, ie below market value, below comparable sales (aka comps). In our brokerage, we don't let our clients pay retail; I always aim to get them a property below the comps.

This is why a simple DIY / fixer-upper is so attractive to new investors. You can really hit the ground running and pay less for that renovation by doing some yourself. And when you start adding bedrooms, bathrooms, or overall square footage you should see even higher returns. Savvy investors look for properties where they can add value like this. The key is to look for properties with less than the ideal number of amenities (ie bathrooms etc…), and then add what they are lacking to create the most value.

#4 - Tax Depreciation

Yes, your property is appreciating, in value, but it is also slowly deteriorating, literally, which means you have to spend money to repair and maintain it. The government recognizes this, and much like equipment or durable goods a business owns, you can depreciate the value of the asset, thereby deducting a percentage of the property’s total cost from your taxes. For residential real estate, the IRS allows rental property investors to deduct 3.636% of the value of the structure of a property each year over 27.5 years. For example, if the value of my real estate is $500,000 and the land is assessed by the tax man at $100,000, the value of the structure is $400,000. Thus, you can deduct $400,000 * .03636 = $14,544.00 off my taxes every year. In practice, depreciation is used by the savvy investor to shield much of the cash flow earned from taxation. You can also accelerate this depreciation, but I’m not getting into that here. (* Required legal disclaimer: I’m not a CPA and this is not financial advice).

Your Primary Residence is Not an Asset, It’s a Liability

This is as good place as any to make this point. You can cannot depreciate a home you are living in (yes there are some nuanced exceptions but I’m not getting into that here). This is one of the fundamental reasons why owning your primary residence should not be considered an asset or investment, even if you happen to make a net profit selling it in the future.

Think of it this way: if you took that same money and bought a rental property instead, which you could depreciate, add value and raise rents on over time, while at the same renting your primary residence, you would make a significantly higher return, and have cash flow you could reinvest.

There is an old adage, “[rent where you live, rent-out what you own].”

Don’t get me wrong, it is amazing to own your own home. I do. But that is an emotional decision, not a financial one. I like owning my own home. I don’t want a landlord telling me what I can and cannot do (one reason I stay away from condos and HOAs too). I have a dog. I may get a few chickens. I have a garden. I park my car in any spot I want to. Tomorrow, I’ve actually got a pretty nice little Saturday planned, we’re going to go to Home Depot, buy some wallpaper, maybe get some flooring, stuff like that. Maybe Bed Bath and Beyond, I don’t know… I don’t know if we’ll have enough time!! (bonus points for getting that reference :).

So what have we learned?

Is owning where I live maximizing my returns?

No.

I would make more money if I moved out, rented-out my home and rented my primary residence. And even more money if I moved out my cars from the garage, finished the basement and added two more bedrooms, maybe a bathroom.

Now that’s adding value. :)

#5 - Cash Flow (aka Cash Now)

Lastly, we have cash flow, or Net Operating Income (NOI). This is how much cash is available each month after taking the difference between all money coming in and going out, including loan payments, maintenance, taxes, insurance, management fees, repairs, other expenses etc… (ok, technically NOI is not the exact same as cash flow, and is actually a more accurate definition as cash flow is actually a more broad calculation in business. But, in residential real estate parlance they are often used interchangeably, so I won’t go into the difference here. Just know there are technical differences).

Put simply, how much cash is in your property’s checking account each month after you pay for expenses? If you have more money in the account, congrats! You are in the black, as they say. You are cash flow positive.

Now, you don’t have to be cash flow positive to invest in real estate and make serious money, but it sure does help. I’ve had a few places where, in the beginning (first 2 years) I was not in the black. They “lost” money each month. But the areas were so hot, the properties appreciated 22%, or several hundred thousand dollars, which is why I bought them. It would literally take me decades to make a fraction of that return in cash flow. And, since I own a portfolio of properties, I could use the negative cash flow to offset cash flow gains from other properties I own, lowering my taxes.

Cash flow is key, I don’t recommend negatively cash flowing unless you deeply understand the risk. Cash flow de-risks your leveraged investments so you don’t get into trouble, can’t pay the mortgage and the bank forecloses on your home.

That would be no bueno.

Cash Flow Evolves

As you can tell, I am intentionally downplaying the importance of cash flow, at least in the beginning. Cash flow is like a house plant. It starts out small. You have to nurture it. But over time, it grows. You raise rents. Yet, your long-term debt stays fixed (thank you America). Yes, property taxes and insurance (especially in some parts of the country, watch out) will tick up, but rent increases should cover those costs.

Do you buy real estate with the intention of holding a property for only 1 year?

No. We are investors.

That’s not why we do this (unless you are flipping, which is not investing, thats a separate business / job and is taxed at a much higher rate to boot).

So as it grows, cash flow becomes much more important later. In fact, I would argue… it evolves.

Cash flow grows slowly over time until BAM!…something very powerful happens…The mortgage just…disappears.

It’s been 30 years, you now own the property free and clear. But….how many properties do you own now? If you have been slowly, conservatively acquiring and renting out properties you may own 5, 10, 30+ properties? Without any fancy tricks or schemes.

Now you have some serious cash flow. And each year another loan vanishes.

At this age in your life, cash flow is important. Cash flow is how you retire. Social Security is not reliable, and was not purpose build for retirement. Don’t rely on it.

But it does take time. Real estate is not a get rich quick scheme. Anyone who says otherwise is lying. Don’t listen to the gurus. Investments grow slowly and compound over time. And don’t forget our old friend depreciation. Again, we only pay taxes on our cash flow after we account for that depreciation / tax deduction (3.636% / yr). The result? Investors pay very little taxes on the cash flow income. Especially in the beginning.

So I recommend not chasing cash flow early. Allow it to grow and evolve into a big green monster. Of course, if you find a great deal that can net you higher returns early, by all means jump on it. But chasing cash flow as priority #1 will likely suck you into either one of two things: high risk D-class neighborhoods and underperforming markets that will under-appreciate. That’s how folks achieve mediocre results, or worse, lose their shirt.

In investing, Rule #1 is never lose money. Rule #2? See Rule #1.

Protecting your downside is more important than maximizing your upside.

Cash Flow Buys You More Real Estate

As your cash flow grows, you can use it to buy more real estate. As your rents tick up, you can choose to refinance: replace the mortgage with a larger one it can now support, and pull equity out of the property in the form of cash. The best part, the cash you pull out is debt, not profits, so you pay no taxes on it. Zero. You can then use those funds to purchase more real estate. I have properties I have owned for a long time in great areas that I have refinanced multiple times. Real estate mogul Barbara Corcoran has spoken about this same tactic. She has one property she has refinanced 9 times over the decades.

What did she do with that tax-free cash?…

“[I prefer to refinance and pull money out]. I’m talking about a lot of money back out. I’m not saying I had a mortgage of $200,000, I put 250 on it. I would wait five years. For the $200,000 I would then put an $850,000 mortgage on put in my pocket. Listen, refinancing is the way you really get rich in holding real estate that’s what I never like to sell. It’s just a bank that’s going to keep on giving. That’s how I look, I feel like I’m in the banking business, but I have real estate to back it up.”

— Barbara Corcoran

Growth Markets > Cash Flow Markets

The above is why savvy investors seek growth markets. The ability to add value, grow rents, and refinance an appreciating property. This is also called the BRRRR method, as coined by David Greene.

So, when I’m looking to invest I want an area where assets supply is low/constricted and/or demand is strong/growing, population is increasing, unemployment is low, job openings are attracting new workers, wages are growing, and the property is in the path of growth.

My Skeptical Take:

Real estate allows an investor to buy and control a large asset, while only paying for a small percentage of its cost. The asset pays for itself, the investor makes an ever-growing income each month, the asset’s value can be forcibly appreciated, they build immense wealth and pay little in tax.

Remind me why only 6.7% of the population does this?

Well, three is one catch, conventionally (no pun intended) you need money to buy real estate. Saving 25% for a down payment + closing costs is nothing to scoff at. And yes hold your responses, there are creating financing strategies to buying real estate such as owner financing, subject-to, raising capital, partnerships, syndications etc…but I’m not going to get into those here. I’m talking classic, tried-and-true - and yes potentially more conservative - real estate investing. To grow immense wealth it doesn’t need to be complicated or risky. You just need to Work, Save, Invest, Repeat…WSIR! (Not a cool acronym I'm afraid, let me workshop it)

To succeed you have to be, as Theodore Roosevelt put it, “In the Arena.”

We all want to grow our wealth for our us and families. The only question is, what are you going to do about it?

Until next time. Stay Curious. Stay Skeptical.

Herzliche Grüße,

Andreas Mueller