Why Real Estate?
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You may have heard that real estate investing has created more millionaires than any other asset class. And while this is true, you likely haven’t considered that real estate is also responsible for countless bankruptcies.
This reality begs the question: How risky is real estate investing? And do the rewards outweigh the risks? We can start to answer these questions by looking at other popular forms of investing.
The stock market: Since the inception of the Dow Jones Industrial Average in May 1896, the index’s average annual return has been 5.42%. Over the past 10 years the average returns of the S&P 500 is 14.7%, while the Dow is 15.03% - both well above historical averages. The stock market has rewarded many investors over time with inflation-beating rates of return. However numerous factors influence the stock market, making it a very volatile (up one day, down the next) investing tool. For example, most stock indexes dropped 4-6% in 2018, the worst record in 10 years. The economy, inflation, and market value risk are only a few of the major factors that affect the stock market. These factors are out of the investor’s control, and thereby pose a legitimate risk to investments.
Banks: You’ve likely heard the phrase, “Like money in the bank!” But is this sentiment all it’s cracked up to be? Banks can provide a high level of security through FDIC insurance, and also keeps your money liquid, granting you ease of access. But from an investment standpoint, keeping your money in a savings account will cost you buying power over time.
Example: you have $100 in a savings account that pays 1% annual interest. After year 1, you have $101 in your account. However, if the rate of inflation is running at 2%, you would need $102 to have the same buying power you started with.
Because 99% of savings accounts fail to beat inflation rates, you are almost guaranteed to lose money by leaving it in the bank.
Start a business: Many people will channel their passions and skills into a business. By investing in yourself you can be your own boss, pursue your entrepreneurial dreams, and work towards financial freedom. However, starting your own business also presents a litany of caveats: abandoning a steady paycheck, sacrificing personal capital and time, establishing a trustworthy team of employees, etc. Not to mention the common statistic that 50% of small businesses fail within five years (Bureau of Labor Statistics).
There are many other approaches to investing that we can’t cover here, including cryptocurrency, luxury assets, precious metals, federal bonds, etc. But only one asset class is truly the IDEAL form of investing.
Why real estate is the I.D.E.A.L. form of investing:
I - Income
Income can be created through several channels, mainly the monthly rent paid by your tenants, aka “cashflow.” Cashflow is determined by your gross rent - your expenses= Net Operating Income (NOI). If you have a mortgage payment for the property (you Likely will) then you deduct your payment (aka Debt Service) from your NOI to determine cashflow earnings.
D - Depreciation
Depreciation lets you deduct a portion of the cost of your investment each year for thelength of its IRS-designated life-span. The deprecation computation is figured based onthe value of the improvements, not on the land underneath the improvements. Thisnecessitates that you be able to determine the value of the land and the value of theimprovements.
It’s important to keep in mind the depreciation recapture, which is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset used to previously offset taxable income. Depreciation recapture on gains specific to real estate property are captured at a maximum of 25%.
E - Equity buildup
Equity is built through repayments of the principal or remaining balance of the loan(s) taken to purchase the property. As you amortize your mortgage, your equity will increase. In essence, your tenants pay your mortgage and help you build your estate. By using OPM (other people’s money) you eliminate the need to raise your own capital, and minimize personal risk in your investment. You can also create equity right out of the gate by purchasing a property for under market value.
A - Appreciation
One aspect of making a great deal is finding a property whose value increases annually. Natural or passive appreciation can result from inflation or increase an increase in demand outweighing available supply. Historically, property prices and rent have appreciated roughly the same rate as inflation (~3.4% annually). Forced appreciation, on the other hand, refers to the increase in value of a property resulting from the investor’s actions. Forced appreciation can be achieved in several different ways, including: increasing monthly rent, minimizing vacancy rates, creating additional living space, adding amenities, decreasing expenses, etc. Ultimately, appreciation can make a buy and hold approach to investing very rewarding!
L- Leverage
In real estate investing, leverage entails the use of various financial instruments or borrowed capital (debt) to purchase and/or increase the potential return on investment (ROI). When you put 20% down and borrow the remaining 80% for a rental property, you are leveraging a small amount of money to acquire a more valuable asset. For example, if you save $100,000 you can either purchase one property for $100,000, or leverage your money by putting down 20% ($20,000) to purchase 5 properties. Now, you multiply your cash flow, depreciation, appreciation, and equity x5! Leverage allows you purchase more assets and scale more quickly.
Some risks to bear in mind when using leverage include: overestimating appreciation, maintaining too high mortgage payments, allowing favorable financing blind you to a bad deal, etc.)
Bear in mind that while each of these I.D.E.A.L. aspects of real estate investing can contain wealth building potential, none of these are 100% risk free. In all decisions, you should never jump in without a sound understanding of the potential risks as well as rewards. When it comes to investing, a diversified portfolio is the best way to mitigate risk.
How can LiveFree Investments help you?
Access to off-market transactions that can be purchased at considerable discounts to market values; this provides significant downside protection for investors
Most returns on investment (ROI) are created from in-place cash flow from rental income, which is less volatile that appreciation-based investments
Because real estate properties are tangible assets, this form of investing has historically held its value well during both inflationary and deflationary periods
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