Real Estate is the “IDEALL” Investment
Written by Ken Holman
I know, you think I spelled the word “Ideal” incorrectly. Well, it’s true; I did intentionally misspell the word. “IDEALL” is an acronym an associate of mine devised to describe the benefits of real estate as an investment.
“I” stands for Income Producing. It doesn’t matter whether you invest in a residential property or a commercial property as long as it produces income. Income provides monthly cash flow, which over time, can grow into a sizeable sum. Cash flow is the money left over at the end of each month after the expenses and mortgage payments has been made, Income-producing real estate provides a consistent monthly cash flow.
“D” stands for Depreciation. The Internal Revenue Service (IRS) permits those who own real estate to deduct from their income an amount for wear and tear on their property. The IRS permits you to depreciate the building but not the land. For residential properties, you can write-off the cost of the building over 27 ½ years. For commercial properties, the write-off is over 39 years. In addition to depreciation, the IRS taxes real estate at a lower rate of 15 or 20 percent, depending on your income, when the property is sold. (For specific information you may wish to consult a CPA.)
“E” stands for Equity Buildup. When a tenant leases or rents a property from you, part of the income you receive can be applied to the monthly mortgage payments. As you pay down the mortgage balance, a portion of the payment is applied toward a reduction in the principal balance of the loan and the rest is paid toward interest. So, your tenant is literally paying off your mortgage for you, month-by-month. This monthly reduction in your loan balance reduces the debt you owe on the property and increases the equity you have in the property.
“A” stands for Appreciation. Appreciation is the measure of how much your property has increased in value over time. Appreciation can be caused by increasing prices due to inflation, by increased demand, or even by improving the property. In 1985, the average cost for a new home was $96,200. Today, the average cost of a new home is $341,000. That’s an annual increase of 4.3 percent. Real estate appreciates in value over time. It’s a proven fact.
“L stands for Leverage. Leverage is using borrowed capital to increase the potential return of an investment. Real estate is one of the few assets that banks will lend money on at an interest rate that is below the rate of appreciation.
Here is a quick example of leverage Say you had $100,000 to invest in real estate and for that amount you knew the property would generate $8,000 percent cash-on-cash return on your investment ($8,000 / $100,000 = .08 or 8%). Now say you invest $25,000 of your own money and borrow the remaining $75,000 at 5 percent interest with the loan amortized (paid off) over 30 years. The annual total of the monthly mortgage payments would be $4,831 which would reduce your cash flow by that amount. Now you have a net cash flow of $3,169 instead of $8,000, but the cash flow you receive is on a smaller cash investment, i.e., $25,000 instead of $100,000. What is the cash-on-cash return on that investment? It is 12.67 percent instead of 8 percent. You’ve increased your return cash-on-cash return on your investment by 58 percent using the bank’s money.
Since real estate is a favored investment by banks, the concept of leverage works in your favor. If you tried leveraging a stock investment, it wouldn’t work the same way because banks view stocks as a more risky investment. They won’t lend as much on stocks and they charge an interest that is higher than the return you can achieve.
“L” – the other L – stands for Legacy. Legacy is the amount of money or property you leave to your heirs. Most financial planners consider that when you retire you will need enough annual income to support you for 25 years. To calculate the amount of money you need at retirement, take your annual income and multiply it by 25 and then add a factor for inflation and that is the amount you should have in the “in” net worth when you retire.
Say you have an annual income of $50,000, multiply that by 25 years and it would equal $1,250,000. Now add inflation at 2 percent per year and you need $2,050,000 at the end of 25 years to comfortably retire and maintain a lifestyle you now enjoy.
If that money is invested in mutual funds or other stocks, you have to liquidate 4 percent of your portfolio each year to have enough money to live on. At the end of 25 years, you not only have nothing to live o, but you have no legacy to pass on to the next generation. Real estate, on the other hand, doesn’t have to be liquidated at retirement. You live off the cash flow that I generated. The cash flow keeps pace with inflation, so you never have to liquidate the asset. It is available to pass on to the next generation.
From my perspective, real estate is the IDEALL investment. It provides a consistent cash flow. The income taxes you pay on the earnings are reduced by the interest and depreciation you can deduct. Your tenants pay down your mortgage so you are constantly building equity. The property appreciates in value over time. Real estate can be leveraged because banks are willing to lend you money at rates that are below the return you can achieve on the investment. Not only that, but you can purchase four times more assets that appreciate in value because of the ability to leverage your investments. And, finally, you can leave a legacy to the next generation. In my opinion, real estate truly is the IDEALL investment.