5 Ways to Build Wealth Through Real Estate Investing

Event Planning, Planning & Saving, Real Estate
on June 15, 2015
Five Ways
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When people talk about real estate investing, they often erroneously assume their return depends solely on whether the value of the home goes up or down. In fact, one myth created in the popular media is that you can’t make significant money in real estate because it only goes up about 1% more than the inflation rate each year.

While that may be true for your primary residence, it completely misses the boat on real estate investment properties, and thus keeps people from understanding how substantial wealth can be easily created from owning real estate. The fact is that there are five different ways owning investment real estate can help create wealth for you. And here they are:

1. Appreciation of the asset.  Yes, it is correct that residential real estate appreciates on average over the long term about 4%-5% a year, and that this is generally only about 1%- 2% above the inflation rate. But this is not the only way that we make money on our investments!

It is also true that if you purchase real estate when it’s really cheap, as in the periods from 2000-2003, or 2009-2011, your appreciation rate over the next few years is likely to be far greater than the historical averages.

Also keep in mind that as the property appreciates, it is compounding the return that you receive. The $200,000 home becomes $210,000 the first year, but then $220,500 in year two as the 5% appreciation is compounded off the higher value achieved after year one.

2. Cash flow. This is the money that comes from renting real estate to tenants. Think of rent like a stock dividend. Whether the value of the asset—be it stock or real estate—goes up or down, the dividend (rent) is paid out every month. By taking in more from rent than you pay out in expenses (mortgage, taxes, insurance, repairs), you create a positive cash flow on a monthly basis.

3. Principal pay-down. When you have a mortgage on a property, part of the monthly mortgage payment (that you pay from your rent) goes toward the loan principal. Over time, the principal that gets paid off builds up equity in your property.  When you sell, or if you ever refinance the property, you will collect that equity at the closing table.

4. Start-up equity. When you buy a property that is sold as a distress sale (foreclosure, short sale, estate sale, etc), and fix it up, the difference between the after repaired value (ARV) and the amount you paid + repairs/improvements is called “sweat equity”.

For example, if you buy a home for $150,000 and spend $30,000 on repairs or improvements, and the newly remodeled home is then worth $220,000, you have created $40,000 worth of sweat equity.

5. Tax benefits. There are a number of tax benefits to owning investment properties, and although you won’t actually see that money in your pocket, it will come back to you in the form of deductions that will reduce your income taxes. Money spent on mortgage interest, insurance, repairs, and association dues is all tax deductible. You can even deduct half of your travel and meal expenses if you have to travel a distance to where your properties are located.

Another way to reduce taxes through real estate is that your rental properties can be depreciated every year for 27.5 years.  You can also defer taxes on properties you sell by either using a Self-Directed IRA or a 1031 Tax Deferred Exchange.

So now that we see all the different ways to build wealth, let’s take a look at the actual potential return we can generate in our first year on an investment property:

Since foreclosures are generally sold for about 20% below comparable homes in the neighborhood, let’s say that we buy a foreclosed home for $150,000 in a neighborhood worth $190,000 after repairs are made. We put $30,000 down, spend $15,000 on repairs, and $5,000 on closing costs ($50,000 total). We finance the remaining $120,000 over 30 years at 4.375%.

Our $120,000 loan payment is approximately $600 per month for principal and interest, plus another $300 for taxes and insurance. Our total monthly payment is thus $900.

Let’s say the home rents for $1,300 per month, so after subtracting the monthly payment, we have a $400 positive cash flow. Our principal pay-down over the first 12 months of payments is $1,979. At the end of the first year, the $190,000 home is 5% higher, or worth $199,500.

Let’s add all of the numbers after one year to see our pre-tax return:

Appreciation at 5%

Positive cash flow

Principal pay down

Sweat Equity

TOTAL

$9,500       +

$4800     +

$1979     +

$20,000   =

$36,279

Cash out   of pocket

$50,000

Adding the appreciation, positive cash flow, principal pay down, and sweat equity together, the total is $36,279. Now divide $36,279—not by the $150,000 sales price, but by the $50,000 actual money out of our pocket. Our first year return becomes an amazing 72.5%!

Remember, we only pay capital gains taxes on the rental income. Those taxes are then reduced by the expenses we incurred during the remodeling and the rest of the year (probably 10-11 months of actual time since we had remodeling down time).

These are not pie-in-the-sky numbers. I have made returns like these many times in my 20 years as a real estate investor.

So the next time that you hear someone ask What good is real estate investing if you only make 1%-2% above inflation a year?—just smile and remember that by using this formula, you can build wealth faster in real estate investing than almost any other asset class, and far above the popular misconceptions that are so often quoted.

Ethan Roberts is a real estate writer, editor and investor. He’s a frequent contributor to InvestorPlace.com, and his work has been featured on Money.msn.com, Reuters.com and Auction.com. He’s also written for SeekingAlpha.com and MarketGreenhouse.com, and was one of five contributing editors to TheTycoonReport.com. He’s been investing in real estate since 1995 and has been a Realtor since 1998. He also teaches classes on investing in residential real estate.

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