There are a total of 5 different ways to earn money through any asset. Recently, I was reading a book from one of my favorite authors, Robert Kiyosaki. He is famous for his book ‘Rich Dad, Poor Dad’. The book is so popular that it’s almost considered to be the bible for real estate investors because of its sheer evangelistic capability. One of the points Robert speaks about is the 4 different asset classes: Real Estate, Paper, Commodities, and Businesses.
Out of the four asset classes listed above, real estate is further special than the rest because it is the only one that allows you to earn money through all five ways at the same time. The remaining asset classes don’t allow you to earn money through all five ways simultaneously. It is the reason why real estate is an I.D.E.A.L investment.
IDEAL – Five Different Ways
- Income (Cash flow)
- Depreciation (Tax benefits)
- Equity gain through loan payments
- Appreciation over time
- Leverage (Getting lending to buy the property)
Income from real estate refers to positive cash flow on a rental. Let’s say you have a rental property that you are renting for around $1,200 a month. After paying your principal, interest, taxes, insurance, property management fees, etc. from the $1,200, you are left with $150 in positive cash flow at the end of the month. Real estate allows you, if you purchase it correctly, to have a positive cash flow and earn money at the end of every month. And this is the real intent and purpose for which investors buy rental properties.
One of the reasons why most investors tend to avoid high dollar value properties (300k and greater) is because they usually don’t have positive cash flow. The rent will not be enough to cover the PITI, which is Principal, Interest Taxes, and Insurance.
In this context, Depreciation is a catch-all phrase that refers to tax benefits. When you buy a property, the government incentivizes you to hold the property for a long time. The tax code has been written to reflect this. When you buy a single-family home as a rental, the government allows you to depreciate the property over time: twenty-seven and a half years. Let’s take an example, if you bought a property for $100,000 and you were able to claim depreciation on it over 27½ years, the depreciation amount will be slightly less than $4,000 a year. Do you have to spend this $4,000 on the upkeep of the property? No, you don’t. It is a phantom expense, which the government allows you to deduct from your income. Therefore if your positive cash flow, as mentioned earlier, is less than $4,000 a year, Guess what you pay in taxes? Zero!
If you sell the property within a few years, then the government will not allow you to claim the depreciation. They will recapture it into your tax bill. So before you execute this particular strategy, consult a competent CPA or attorney.
Difference Between Short Term and Long Term Capital Gains
Usually, when you buy a property and hold it for less than a year before you sell it, the government will hit you with a short term capital gain, which is taxed at the same rate as ordinary income. If you hold the property for more than a year, it usually comes under long term capital gains. Which is taxed with a much more favorable rate. This is another way the government incentivizes you to buy properties and hold them.
Equity Gain Through Loan Payments
Going back to our previous example of having a rental property, your tenant is paying $1,200. Your payment to the bank is $800. If you have an interest rate of 5% every month, you are paying down approximately $120 – $500 of your principal each month. You can find this information on your amortization chart.
In your first year, you are reducing your principal by $120 a month. By year ten, you will be reducing the principal by $200 a month, and so on. In essence, your tenant is paying off your mortgage for you. If you keep the property for 30 years, at the end of 30 years, you would own the property, free and clear, and the tenant would have paid off your mortgage on your behalf! Excellent, isn’t it?
The value of a property rises over time. In recent years the values of property in Tampa Bay have appreciated 7% every year. If you brought a property for $100,000 last year it is worth approximately $107,000 today and next year it will be $114,000 if the trend keeps up. Therefore if you buy a property and hold on to it, you gain substantial appreciation over time. Another word for appreciation is patience. You cannot expect appreciation to happen overnight.
The only exception to this rule is when you’re flipping properties. With flips, you ‘force’ the appreciation through the rehab which is what is realized at the end of a flip.
Leverage is the most often overlooked of the five, but it is a remarkably powerful tool in your arsenal. Let’s take an example: if you buy a multi-family property that has three units, and you live in one of them, you can rent out the remaining two units.
If you buy such property for $200,000 and get an FHA loan to do so, you would have to pay 3.5% of the purchase price to buy the property, which comes to $7,000 plus closing costs. If the property appreciates by 7% at the end of a year, it will be worth $214,000. At the end of year 2, if you were to sell the property, and for a moment, let’s assume that you don’t incur closing costs, you’d make a profit of $14,000 from the sale. In terms of cash invested, that’s a return of 200%.
Piling Advantages One on Top of the Other
In the example mentioned above, your tenants are paying your mortgage for you, you are living rent-free, you have tax advantages, equity appreciation, and to top it off, you make 200% on your initial investment. Sweet, isn’t it?
Stock Market vs. Real Estate
The real estate market functions differently compared to any other asset class. The stock market is the most commonly compared asset class. The reason they function differently is because of the nature of the underlying asset. Real Estate prices move slowly. They are not volatile like the stock market, where the prices fluctuate daily.
Real Estate is a physical asset that you can rent out. Stocks, on the other hand, are not rentable. How would you earn money through your stocks? Very few companies pay dividends, which can equal rent payments. The only way to use leverage in the stock market is trading in derivatives like futures and options. The stock market and real estate have significant differences.
If you want to know more about the difference between the stock market and real estate, then stay tuned for the next article.
ABOUT THE AUTHOR
Jorge Vazquez is a broker and founder of Graystone Investment Group headquartered in Tampa, Florida. He has been in the business for over 20 years and has participated in more than 2000 transactions. Graystone is one of the first companies in Florida with all divisions under one umbrella: Wholesaling, Brokerage, Private Lending, Rehabbing, and Property Management. You can find Jorge at homes4income.com or Graystoneig.com and connect with him to either join his brokerage, invest, or simply to learn more about real estate.