1. Reduce Taxable Income.
Many real estate investors have W2 employment or 1099 employment. Either way, there is tax liability for these investors. How much individuals pay in taxes does not depend solely on what your gross income amounts to, instead, it depends greatly on whether or not you are able to take deductions and navigate the existing tax law. As investors, reducing our tax liability should be just as important as increasing our revenues. Many investors obsess over cash flow. It sounds good. However, let's look at the following investment case study and see what the cash flow crowd is missing out on.
- $100,000 purchase price on a residential property with a 30 year fixed mortgage. In this hypothetical, this property is located in an A or B neighborhood like Parma, Ohio or Strongsville, Ohio.
- Assumptions are as follows: Rental Income $1,000/month, Cleaning and maintenance are 4% of annual income ($399/year), insurance $1,000/year, management fees $1,140, repairs are 5% of total income for a total of $570, property taxes are $2,400 per year, and utilities are $900/year.
- Cap Rate 5% and Cash on Cash of -0.8%.
The vast majority of investors are not doing this deal. They think these returns are lousy and are enamored with 20% cap rates. It's hard not to be. Of course, everyone should seek out the best return they can negotiate. However, this is where defining your goals and knowing thyself is very important. I own several properties in D areas. At any point in time a cousin can move in that's just gotten home from jail, rocks fly through windows, apartments are trashed, police are routinely involved, and so on. On paper and in real life I probably do get around 20% in returns on these, but it's been a long road and I've earned every penny. Think you are going to property managed away your problem tenants? Ultimately, it's going to cost you one way or another. Really, the only way you can get those returns is by managing the properties yourself and going through hell. My point: know thyself. If you are starting off in investing, why jump in by taking crazy risks like flipping or going for it all by getting properties that require massive undertakings only to deal with monsters once you're all finished updating the property?
Back to this deal, let's say an investor makes $100,000/year in W2 income. The investor pays $35,000 in taxes. In the aforementioned deal, the area and home nets a highly desirable tenant, a house in good condition, and a great neighborhood with good schools. From your tax bill, you could possibly deduct the following expenses: $3,636 of depreciation, $3,960 in mortgage interest in year 1, maintenance $399, insurance $1,000, management $1,140, repairs $570, property taxes $2,400, and utilities of $900. I am not an accountant, however, these approximates could provide a tax benefit of $14,005. Traveling is a part of a real estate investors costs. If that means traveling to see your properties or scouting out new investments, these could be considered reasonable deductions.
2. Build a Credit Profile
Before any lender is going to do bigger deals with you, they want to see a foot print. Is this your first deal in real estate? If so, you most likely will not secure a $10,000,000 commercial loan. Lenders are cautious by design, why would you take an unknown risk when you can go to someone else who is a sure bet. Building a portfolio of A and B properties commands the respect of lenders. They understand these properties will always pay out and always will be in demand. They would prefer to see those types of properties on Balance Sheet than 20 C and D properties.
3. Principle Pay Down
Someone has to pay your mortgage, it might as well be your tenants. At the end of the day, do you want to be living your life wondering if the woman who has four different jobs over the past six months is going to scrounge up $550 this month or not? Remember, she does not care about your numbers, your data, your software, or your spreadsheet. Why not have a tenant with a good solid employment history pay your mortgage for you? You will not lose sleep. Decide what is more desirable to you. A hypothetical $550/month with a hypothetical 20% cap rate. Or a real $1000/month at a real 5-7% cap rate?
4. Appreciation
The word that no realtor is ever supposed to talk about, appreciation. No one knows where the market will go in the future. However, as real estate investors we know that there a few likely possibilities. Prices could go down and that would be bad in the short term. Prices could go up nominally. Prices could also go up in real terms. The factors that are at work in macroeconomics are the supply vs. demand of a specific asset class, deflation vs. inflation, and appreciation vs. depreciation. Let's start with supply vs. demand. The population is exploding. There's no shortage of demand for functional housing. The only question is can these folks buy houses or can they be good tenants? That's a real question. Nevertheless, by 2037, we are expected to hit 9 billion.
If we see inflation, our loans immediately are degraded for us, we can raise our rents, and prices rise. If we see deflation, that may only be good for those holding properties free and clear, but on the bright side for the rest of us the next property you purchase may be cheaper. Realistically, many market makers desire inflation, however, we must understand the effects and risks of both.
Finally, appreciation. Currently, we experiencing growth in many cities year over year of 5-10% increases in home values. Appreciation is possible just not guaranteed.
5. Diversification
Many investment advisors tell you to put your savings into a variety of funds: ETFs, Fixed Income, REITs, Equities, and so on. With the exception of some types of bonds, these are not tax favored assets. You are banking on business performance in the case of assets with yield or you are simply banking on appreciation for assets without yield. Being a real estate investor allows you to be a direct investor in a tangible asset. You can make money in a variety of ways: rent, appreciation, insurance claims, air rights, water rights, mineral rights, and so on.
Real estate allows you to invest in an area that many investor refuse to participate in due to fragmentation. Real estate is a long term wealth creator. True, cash flow is nice to have, however, there are many other benefits to investing in real estate besides hoping to have some money left over at the end if the month. Not enough focus is placed on these other benefits. Cash flow is a big component of the puzzle, but it should not be the only factor considered.
