Why invest in real estate

I’m sure you’ve heard “real estate is a good investment”. But why is real estate a good investment? Here’s why:

Cash Flow

Investing in real estate can produce cash flow, which is the money left over after paying all operating expenses and the loan payment. This is perhaps the main draw for investors to buy real estate opposed to other asset classes. Cash flow can be used for many purposes. If you’re just starting out, it would be ideal to save it up for another investment property. If you’ve been investing for a while and have many properties, you can start to live off your cash flow.

Appreciation

Real estate typically appreciates over the long term. You can realize the benefits of appreciation on your investment when you complete a cash out refinance, draw on a HELOC, or sell your property. A cash out refi is when you pull equity out of your property by appraising your home and refinancing on a portion of the newly appraised value. The difference between the new loan balance and the old loan balance is provided to you in cash. You can do this because over time you will have built equity in your property through loan amortization, market appreciation, renovations, or operational improvements. Whether you realize the appreciation through a cash out refi, a HELOC, or a sale, you can use the proceeds to invest in another property.

Leverage

Real estate investors often use leverage, or debt, to purchase properties. Leverage is useful to investors because it enhances their return. For example, an investor buys a $200,000 property with all cash and sells it in five years for $250,000. The profit on the investment is $50,000 or a 25% return on investment. Not bad. But what if the investor only put down $40,000 and financed the remaining $160,000, selling five years later for $250,000. The profit on the investment is still $50,000 but the return on investment is now 125%. Significantly better when compared to the all-cash deal. An added benefit is that the investor can take the $160,000 he/she would have put down on the all-cash deal and invest it elsewhere.

Tax Benefits

There are also many tax benefits to investing in real estate. Depreciation on the property can be written off every year and oftentimes this amount offsets rental income, leaving the investor with tax free cash flow. Maintenance, repairs, and other business expenses can be written off as well. Another great benefit comes when you’re ready to sell your rental property. The capital gains tax can be avoided by exchanging the property for another one. This is what’s called a 1031 exchange.

Loan Amortization

Each month you should receive rent from your tenant(s), which you’ll use to pay operating expenses and then pay down your loan. A loan payment is composed of principal and interest. At first, your monthly loan payment will consist of mostly interest but as time goes on you’ll start paying more towards principal as the loan balance decreases. Each month the proportion of principal to interest in your payment increases. Over time, the equity in your property increases in exponential fashion. This process is called loan amortization.

Opportunities to Add Value

Think of real estate as a business you purchased. It has operations just like any other business (revenue, expenses, profits, losses, etc.). You’ll have opportunities to increase revenue or decrease expenses, giving you a degree of control over the investment, which cannot be done with stocks, bonds, or other passive investments. Maximizing profit on your real estate investment can be done a number of ways. Does one of your units have a stunning view of the city that the previous owner didn’t take into account? Increase the rent for this unit. On the other hand, you can look for opportunities to decrease expenses. Maybe you can lock in a discounted rate on landscaping by signing a long term contract or install energy efficient light bulbs. These are just a few examples of opportunities to add value.

Conclusion

There are other benefits to investing in real estate, such as hedging against inflation, providing housing for you community, tangibility of the asset, etc. Real estate isn’t for everyone so be sure you understand the drawbacks before you start investing, but overall, I believe real estate is a great way to build wealth.