I’ve come to find that everyone has an opinion. Many of these opinions are pessimistic in nature and are given with the objective of turning away or discouraging action. This “advice” usually comes from individuals who have either failed, or just never really succeeded in the topic at hand. Those that advise against traveling are individuals that have never seen the world and those that despise entrepreneurship are the ones that haven’t enjoyed the fruits it provides.
When I first started investing in real estate, I received a lot of “advice”. Now, 58 doors later and netting over $19,000 a month in passive income, I can say in full confidence that most of that “advice” was counterproductive. However, I was lucky enough to have mentors with the right information to help lead me in the right direction. One of the biggest things I learned immediately was that debt, if used correctly, is one of the greatest assets available. I consistently get asked, “When are you finally going to pay off your loans?” My answer is always the same:, “Never!”
Real-estate is all about leverage. If done correctly, one can invest $25,000 like it’s $250,000.
I know that math seems extreme, but let me explain.
In real-estate, income can be earned through four avenues: Appreciation of the Property, Cash Flow, Pay-Down on the Loan, and Tax Savings. If the property is owned outright, only a small portion of these potential returns can be capitalized on. In this article, I will explain these avenues more in depth and discuss the considerable advantages that come through leveraging property with debt.
Appreciation
Appreciation should always be present when a property is purchased correctly. If someone buys a home with a loan, they can leverage the loan through good appreciation, which becomes a huge advantage.
According to Zillow, U.S. home prices are appreciating at an average annual rate between 3 and 5 percent
(depending on the index used for the calculation). [1]
This means that almost all properties increase in value every single year.
Here is an example to better explain:
Consider a property is for sale for $100,000. If purchased outright, the home value would go up $62,889 to $162,889 after ten years if a 5% annual appreciation is assumed. Alternatively, what if that $100,000 was used to purchase ten properties all costing $100,000? In this scenario, $10,000 would be used as the down payment on each property, while the remaining $90,000 is borrowed on a loan. This situation allows $1,000,000 of real-estate to be purchased. At 5% appreciation each year, after ten years, these home values would go up $628,894 in value to $1,628,894. That is a 628% return on the $100,000 in comparison to a 62.8% return if just the single property was purchased outright. This is literally ten times the return just in appreciation.
Cash Flow
When investing for cash flow, special attention needs to be paid to property taxes, insurance, management fees, loan payments, and all other expenses. Once all of these factors are subtracted from incoming rents, pure cash flow remains.
Cash flow is the most important number to watch in buy-and-hold investing. If an investor is not cash flowing, they are losing money.
However, there are some investors that choose to buy property with negative cash flow purely to capitalize on appreciation. I do not agree with this method because I believe the risk is too high for the potential return. In my mind, losing money every month for a potential payout down the road is not passive income.
Cash flow is also one of the biggest reasons why some investors want to own their properties outright opposed to owning them on a loan. Owning a
property outright allows for increased cash flow because the mortgage payment has been eliminated. What some investors miss is that though this maximizes cash flow, it consequently minimizes the return on investment (ROI). To illustrate this concept, here’s an example:
Assume a property is purchased for $100,000 in cash. Rent is $1,000 per month and the combination of taxes, insurance, fees, and all other expenses are $250 per month. This leaves the cash flow at $750 per month or $9,000 per year. To find the ROI, the $9,000 return is divided by the initial investment of $100,000. This means that this investment produces a 9% yearly ROI.
Now, assume the exact same property is purchased with 10% down on a 30 year loan instead of being purchased outright. At a 4.5% interest rate, $90,000 is borrowed with only $10,000 down. The numbers will be left the same with rent at $1,000 per month and expenses at $250 per month. However, because there is a loan, a $456.02 monthly payment on the loan must also be subtracted from rent every month. This would mean that the cash flow drops to $293.98 per month or $3,527.76 per year.
The cash flow is lower, but the return is much higher because only $10,000 versus $100,000 was invested. This means that the yearly ROI is 35.27% in comparison to the 9% return if the property was owned outright.
This concept confuses people because they only focus on cash flow being lower with the loan scenario. Remember, an investor that takes out a loan still has $90,000 to invest. If this money is invested in nine more properties with the exact same numbers, the yearly cash flow is at $35,277.60 in comparison to the $9,000 in yearly returns of owning one property outright.
Paydown on the Loan
When I previously discussed cash flow, I treated the paydown on the loan as an expense. This was to make the example clear when, in reality, part of the mortgage payment is just like putting money into an appreciating savings account.
For this example, view the chart below.
Notice that part of the mortgage goes toward interest, while the other part goes toward paying down the loan (the principal). Over time, there is less and less interest, while more and more of the payment goes toward the principal (the amount borrowed). This lowers actual expenses every month while upping returns.
Taking out a loan is like putting money into a property that acts as a savings account.
As each month goes by, the portion of the loan payment going toward the property grows exponentially as the portion going toward the interest shrinks. This means that when the property is sold or refinanced, this money can be pulled back out with appreciation.
Tax Savings
A common misconception about rental properties is that the income made off of them is taxed as capital gains at a lower rate. This is just not true. Money made from rental properties is taxed as real income just like any other personal income. However, there is the option to write off depreciation, interest (if purchased with a loan), and all other expenses. All of these lower the taxable income.
Let’s consider the scenario where a $100,000 property is owned outright and it is cash flowing $9,000 per year. In this case, depreciation doesn’t offset all of the income. This means taxes must be paid on a portion of this income and, depending on the tax bracket, can really hurt the net income after taxes (NAIT). Alternatively, if this property is leveraged, the ROI is equivalent to the NAIT because none of that income is taxable. This income is not taxable because the cash flow is small enough to the point where the expenses offset the income.
This is why investors that use leverage completely avoid paying income tax on the cash flow from their properties.
It's easy to see that the ROI for a leveraged property in comparison to a property owned outright is astronomical! Some investors still argue that the risk of leverage outweighs the potential upside. To combat this concern, I would encourage those looking to invest to do the research and understand the numbers. Know the location, rents, expenses, and make sure the cash flow is strong enough to stay in the positive during drops in the market. Get the numbers perfect and don’t buy a property if it doesn’t meet predetermined qualifications. Knowledge is power and with the right information, risk can be eliminated and returns can be maximized.
[1] Miller, M. (2013, August 12). What Does "Normal" Home
Value appreciation Look Like? Retrieved July 31, 2018, from https://www.zillow.com/research/zillow-home-value-appreciation-5235/