Wealth Building Lessons

Real estate is one of my favorite investments and is great for the purpose of creating wealth. It’s highly leveraged and the government gives you several tax deductions to own it. And if done properly it can catapult you to wealth. What’s not to like?

It all started when I attended a real estate bootcamp in the late 1990s. (By the way, I hate bootcamps that charge you $5,000 or more, but that’s a topic for another post. In short they’re not worth it).

The speaker said his father-in-law retired with no assets except his paid off house. He lived off his Social Security checks which were around $500/month. He said if he had bought just one more house and paid it off by the time he retired, he’d be collecting an extra $1,000/month as income. That really got me thinking.

Of course, I got married immediately after that and so the thought didn’t return until I got laid off from my job some time later. At that point I decided to really start reading up on real estate.

Being unemployed is very depressing and rather than complain (of which I did my fair share) I thought it better to learn about investing and have multiple diverse income streams (just like Robert Kiyosaki recommended). Real Estate would be one of them.

The benefits of owing real estate are many as listed below:

Appreciation
Over the long term, real estate appreciates. Depending on where you buy (and when) you may see a little or no appreciation. But generally if you buy in a place like California and hold for 30 years, you should definitely see your house keep up with inflation.

Taxes
If you own residential or commercial property, you can deduct the cost of improvements, just like a business deducts the cost of its equipment. For example assume you buy a house for $320,000 and $275,000 is the cost of improvements and the remaining $45,000 is the cost of the land. Every year you can deduct $10,000 from your other income for 27.5 years until its paper value is zero. (If you’re in the 30% tax bracket, that amounts to $3,000 in savings on your taxes!)

In 30 years, while its book value is zero, it can easily be worth 10 times what you originally paid for it. And if you sell it, you can do a 1031 Exchange (also called a Starker Exchange) and defer your taxes by buying a larger property.

Cash Flow
If you buy real estate with a loan on it, initially the mortgage payments are usually the same if not a bit higher than the rents you collect. Eventually, inflation catches up and the rents exceed the mortgage, providing a nice monthly income stream.

Principal Reduction
When people buy real estate, they usually get a mortgage. If your goal is to pay it off, then you should get a 30 year fixed rate mortgage. (Of course there are a slew of mortgage products currently available, but these might disappear in the near future, or qualifying for them might become very challenging).

The best part is that your tenants help you pay off the mortgage. So every month, as you pay down the mortgage your equity in the property is increasing. This means you’re becoming wealthier every month and your net worth is increasing!

Leverage
You can usually buy real estate with 5-20% down. This means on a $100,000 house you only pay $5,000 and you get a mortgage for the remaining $95,000. So if the property appreciates 2.5% a year (which is what the FEDs would have us believe is the core inflation rate), that means you made a 50% return on your initial investment!

2.5% on a $100,000 house is $2,500. Since you only paid $5,000 down (assuming no closing costs for the sake of this discussion) that equates to a paper return of 50%.

Of course, if you sell your house within 2 years and its only appreciated 2.5%, you probably won’t break even after factoring in your closing costs and commissions. However, if you hold the property for 30 years, appreciating at an average of 2.5% per year your $100,000 house is now worth $209,756.76.

Calculating the rate of return over 30 years on our initial investment of $5,000 we get a 13.25% annual rate of return. And that’s considering a very moderate appreciation rate of 2.5%. Click here now to calculate it for yourself or simply play with the numbers on our calculator page.

Of course, there’s a risk of overleveraging and winding up broke (or even in jail if you’re found guilty of mortgage fraud), but if you’re slow and steady (and aren’t too greedy) you’ll end up richer in the end.

NOTE:
There are a lot of important points in the math and the taxes that I’ve deliberately left out to make it easier to follow. Don’t blindly believe it and don’t whine about it either! Always consult a knowledgeable accountant if you have a tax question.

Related Readings:

• Value Investing in Real Estate
• What Every Real Estate Investor Needs to Know about Cash Flow
• How to Save Thousands of Dollars on Your Home Mortgage

Related Link: Cincinnati Real Estate

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