Buy and Hold Real Estate > 401K

Here comes the controversy!!

I thought it might be fun to do a quick run down on the 5 profit generators of buy and hold real estate... then stack them up against the more traditional 401k retirement strategy. 

There will be controversy, emotion, and you might just throw your laptop or phone across the room. 

Haha kidding of course, but for some reason most people swear by the 401k above all else. Maybe not here on bigger pockets, but I bet if you asked 100 people how they planned to retire early or retire wealthy or both... 95 would say... "huh?," 4 would say that they are contributing as much as they can to their 401k, and one would say from a cell phone on a beach somewhere "I invested in buy and hold real estate". 

Okay, Okay,  I think it's obvious what my biases are, but let's lay them out right off the bat anyway. I think real estate investing is the bees knee's, the cat's pajamas, the beagle's banjo.... etc. I think if you're the type of person who can commit to a consistent real estate investing plan, you'll do much better in real estate than you will with the standard 401k strategy. Let me make my case, and then I'd like to hear what you think.

The 5 Profit generators of Buy and Hold Real Estate Investing

1.) Appreciation:

This is probably the most obvious profit generator. 

Over time, real estate goes up in value. 

There are cycles of course, but over most 10 year time periods your property will have gone up in price. People have made millions through appreciation, especially in cyclical markets. Perhaps for this reason so much attention is paid to appreciation. Often, when comparing the stock market and real estate, appreciation is the only metric mentioned. When comparing this singular metric, the stock market may look like a better place to put your money, especially when you subtract the costs of maintaining your property. Remember though, appreciation is just one of five profit generators, let's look at the rest. 

2.) Cashflow:

As a buy and hold real estate investor this is what should really get your heart pumping. Appreciation is great. Well... it can be really really great. That said I would argue cashflow is what is most important when buying rental properties. Cash flow is income. Income is what builds wealth and what really makes real estate intrinsically valuable. Lot's of things can appreciate... gold, diamonds, bitcoins etc. Only something with intrinsic value and utility can consistently produce income long term. 

3.) Principal Reduction:

This only applies if you have a mortgage (and you should). 

Like appreciation, principal reduction apples whether you are a homeowner or an investor. The big difference as an investor of course is that you aren't the one paying your mortgage, your tenant is! A portion of that mortgage goes towards principal reduction, increasing your equity in the property. 

Imagine if you could borrow a 100k dollars to go back to school to get a better income...

Then imagine you found out that someone else would pay off your student loans for you! 

That's exactly what you can do with real estate.... borrow money to create an income for yourself, and then have someone else pay off that borrowed money for you. 

4.) Depreciation:

Wait what?

I just said real estate appreciated over time, you can't have it both ways right?

Well this is one of those few examples (probably the only example in tax code) where you can have your cake and eat it too. The IRS views real estate (specifically the house, not the land under it) as a depreciable asset. 

(By the way... I'm not a tax person, accountant, or lawyer. Disclaimer!!)

If you aren't familiar with what depreciable asset means let me give you a quick example:

Let's say you go into business and open up a gym and decide that you need to buy a 20k dollar piece of equipment. Well that piece of equipment loses value over time (depreciates). You can go online and determine what the depreciation schedule is for that type of asset... say 10 years, and then deduct one tenth of the equipment's value each year from your gym's income for tax purposes. 

This is nice and all... but you certainly aren't going to get rich spending money on gym equipment and writing off its depreciation. That's because... well... gym equipment actually DOES depreciate. 

Guess what...

Real estate doesn't. At least generally speaking real estate goes up in value... but for tax purposes you get to pretend that it goes down in value. Specifically, you can deduct about 1/27th of your house's value from the income it has generated.

So let's say your house doubled in value this year... for tax purposes it actually decreased in value by 1/27th of its purchase price. Wow! This is what's called a phantom loss or phantom deduction... This is a loss that you can write off that was't really a loss. This isn't an accident, the government wants you to invest in real estate!

5.) Debt Deflation:

Okay I admittedly made this word up I think...

Maybe you could call it.... reduction of debt through inflation?

It's probably the most abstract profit generator of the bunch but I think it is an important one. It works for governments around the world so why can't it work for you?

The idea is this. Generally speaking, we have inflation going on here in America. Probably a lot of debate around this but I think you'd have a tough time arguing that stuff doesn't get more expensive over time. Even things that are supposed to get cheaper... like computers and phones... seem to get more expensive (better too though) over time. 

What this means is that each individual dollar gets less valuable over time. You could buy a lot more with a 1000 dollars 20 years ago than you can now I'm willing to bet. 

This Is why some people would make the case that your money actually goes down in value if you let it sit in the bank and I would agree with that. 

The opposite is also true though. Lets say you borrow 100k to buy a house. Each year that debt is deflated. You get to pay your mortgage back with inflated dollars, and each year it becomes easier and easier to pay back your loan. 

Kind of obscure and more difficult to grasp, but at scale debt deflation is definitely a dimension of real estate that 401k investing can't offer!

6-ish.) Leverage:

Not really a profit generator, but I don't think I can leave this out. While leverage doesn't actually result in putting money in your pocket, it does amplify your returns. It is not uncommon to achieve 10% cash on cash return from cashflow alone using leverage. 

Yes, I know you can technically borrow money to buy stocks, but probably not as easily or at as good of terms as a mortgage. Also, your tenant won't pay back the money you used to buy stocks, but they will help you pay off your mortgage. 

Conclusion:

Buy real estate!

If we only look at appreciation... I think we we could have a legitimate debate. When we combine all 6ish of these factors I think real estate beats the 401k every time. The only time I would recommend 401k investing is to get an employer match, and even then I would only contribute up to your match percentage.

I'd love to hear your feedback on this. 401k troll me baby! 

Alright, the fact remains that either choice is a good one, but let's get a debate going anyway!