The Case for Real Estate Investing as The Best Vehicle for Financial Freedom

TrainHere is a chapter from the soon-to-be published book
‘Financially Free’, written by Damon Janis.

Select Your Vehicle

Determine the Vehicle that will Carry You to Financial Freedom

While there are several vehicles that can be used to achieve financial freedom, real estate is right there at the top of the list. The reasons why are plentiful. I’m going to discuss and explain each reason so you have a firm understanding of why real estate is so effective at building wealth and how you can use it.

Here is a concise list of reasons why real estate works so well to build wealth and financial freedom. Each of these advantages will be discussed and explained in more detail:

  • Capital gains
  • Cash flow
  • Leverage
  • Equity
  • Appreciation
  • Taxes

Capital gains

A capital gain is the profit that results when you sell an asset. For example if you purchased a rental house for $80,000 and two years later sold it for $100,000, your capital gain is $20,000. It’s the sales price minus the purchase price.

The right way to purchase an investment property is to ensure that you will have a capital gain when it comes time to sell it. While you own the property you will have an unrealized capital gain, meaning the gain is theoretical. Once you sell the property the gain is realized and you get the money.

How do you ensure that you will have a capital gain? Purchase the property for a price lower than you will be able to sell for.

It works like this. When you buy an investment property, you need to buy it at a discounted price. The price may be discounted for a variety of reasons, the typical reasons are:

    The house needs some cosmetic work done to make it look nice again.
    The house has a major problem like roof or foundation issues.
    The current owner is going through a personal crisis and needs to sell quickly.
    The current owner is unable to make his mortgage payments due to a job loss or other reason and wants to sell quickly to protect their credit before they default on the loan.
    A bank has repossessed the property when their borrower defaulted on the loan, so the bank is looking to sell the house to cover their loan. Not all but many properties that have been foreclosed need some work on them because they haven’t been treated well.

There are other reasons as well but these are the typical ones. These types of properties are available in every market but usually take a little more work to find.

By joining a real estate investment group or club in your area you can network with people who understand your particular market and how to find these properties. Please see the Resources section for places you can go to find these groups.

Here is an example of how you lock in the capital gain at the time you purchase your property. Working with a mentor in your area you find a property that is vacant. The prior owners were very rough on the house. There are holes in some of the walls, the garage door is hanging on an angle, and there is grime in the kitchen on the counters and stove. If the house were in perfect condition it would be worth $100,000. But given the problems they are asking $80,000 because it won’t sell for more than that.

You recognize that the problems with the house are cosmetic and won’t cost too much to fix. Some dry wall repair, painting, perhaps a new garage door, and a deep cleaning in the kitchen, and new carpets. In your group or club you have access to vendors that do all these things for very reasonable prices so you know it’s going to cost $3,000 to have this work done.

You purchase the house for $80,000, spend another $3,000 getting it clean and functional, and it’s now worth $100,000.

This may sound impossible to you. All I can say is that if you associate with a real estate investment group or club you will see people doing this all the time.

In this example you have locked in a $17,000 capital gain right up front. There is now very little risk that you will lose money on this investment because you controlled how much gain there will be. In the unlikely event that the property loses value it would have to lose 20 percent before you would lose money on the investment.

The capital gain is unrealized until you sell the property. At the time you sell it you will get the capital gain which can be used to purchase another property.

Cash flow

A real estate investment purchased and managed properly will generate cash each month. It will put money into your pocket on a consistent basis.

Cash flow is the profit of operating a rental property. It is the rent you receive from your tenant minus all of the expenses.

Suppose you buy a rental house for $80,000 and you put 10 percent down to buy it. You have a $72,000 mortgage with a 7 percent interest rate. The property taxes on the house cost $3,000 per year and the insurance costs $840 per year. Your tenant pays $1000 per month in rent. This is how your cash flow is calculated:

  • Income 1000
  • Monthly expenses
    • Mortgage payment -479
    • Taxes -250
    • Insurance -70
  • Cash flow $201

Remember that in addition to this cash flow which pays you each month you also have the capital gain.

Compare this to purchasing a no-dividend stock in the stock market. You have no capital gain because you paid full price for the stock and it doesn’t put any money into your pocket. It just sits there and you hope it goes up in value so you can sell it for a profit. That’s called speculation.

With real estate investing you don’t need to speculate and put your money at risk. Lock in your capital gain at the time you purchase the investment and get the cash flow each month.

These two reasons alone make purchasing real estate a better investment than stocks. But we are just getting started. There are many more reasons real estate is such a great investment vehicle.

Leverage

What would your banker say in response to you saying, “Hey, there is this great stock I want to buy. I just know it’s going to go up in value a ton and so I want to buy gobs of it. I only have $10,000; would you lend me another $90,000 so I can buy $100,000 of this stock?”

Bankers are the most conservative people around and they don’t want to loan money if there is too much risk involved. Your banker in this scenario would not lend you the money because it is too risky.

However, if you go to your banker and say “Hey, I’d like to borrow $90,000 to buy this $100,000 house, and I’ll put $10,000 of my own money into the deal as well,” you are probably going to get that loan from your banker (assuming you have decent credit).

Why will the bank loan money to you for a house but not for stock? Risk. There is much less risk in buying a house because there is a physical asset protecting the bank from loss in case you don’t pay back the loan.

Because real estate carries such low risk it is relatively easy to leverage your money. Instead of having to cough up $100,000 to buy a $100,000 house, you only need to cough up $10,000.

This is how leverage works. Using the house from the cash flow example, suppose you have $80,000 in cash in the bank. You purchase the $80,000 investment property for cash. The property will cash flow at about $650 a month (there is no mortgage payment) and you will have $20,000 in unrealized capital gain because after repairs it is worth $100,000.

Let’s look at the return you are getting on your investment. Your return on cash flow on an annual basis is 9 percent ($7,800 cash flow / $80,000 cash out of pocket). Your return on capital gain is 25 percent ($20,000 capital gain / $80,000 cash out of pocket). 9 percent and 25 percent, not bad at all.

Now let’s use leverage by borrowing money from the bank instead of buying the house with cash. Suppose we buy 10 houses with the $80,000 cash, putting $8,000 down and borrowing $72,000 from the bank for each one.

Each house produces $200/mo cash flow and $20,000 unrealized capital gain.

The numbers look like this:

  • Total annual cash flow: $24,000/mo ($200 * 12 * 10)
  • Total unrealized capital gain: $200,000 ($20,000 * 10)

Now look at the return you are getting on your investment. Your return on cash flow on an annual basis is 30 percent ($24,000 cash flow / $80,000 cash out of pocket). Your return on capital gain is 250 percent ($200,000 capital gain / $80,000 cash out of pocket). Leverage increases return on cash flow from 9 percent to 30 percent, and return on capital gain from 25 percent to 250 percent.

That’s the effect of leverage. The cash you spend will go further and produce higher returns when it is leveraged. Since banks view real estate as low risk because the value of the property protects their loan they are willing to lend you this money which enables the money you put into each deal to make more money. The cash out of pocket you put into each deal is more effective; you get more out of it.

Another way to use leverage is by refinancing a property to pull the capital gain out even before you sell the property. There are different rules that apply to refinancing but the general idea is to take out a new loan based on the increased value of a property. As long as the new loan can pay off the old loan and there is money left over, you get that money.

For example, you purchase an $80,000 house, 10 percent down, so you have a loan of $72,000. After repairs the house is worth $100,000. After six months you decide to refinance so you get a new loan for $80,000 (80 percent of the market value of the property). You pay off the old $72,000 loan and get $8,000 back. By refinancing you were able to pull out your down payment which is now available to use on another investment property.

Equity

Equity is the difference between how much your investment property is worth and how much you owe on the mortgage.

For example, you purchase a rental house for $80,000. You put 10 percent down ($8,000) and have a loan of $72,000. After fixing up the house it is worth $100,000. Your equity is $28,000 ($100,000 – $72,000) at the time the repairs are complete.

Now an interesting thing happens over time. As your tenant pays the rent, you make the mortgage payments with a portion of the rent. Each time you pay the mortgage the amount you owe on the loan decreases (if you have an interest only loan this doesn’t apply so I prefer conventional 30 year loans for low monthly payments and principal pay down).

As the loan amount gets smaller your equity grows. When you sell the property you will get more money out of it because the loan is smaller.

The rent your tenant pays is growing the equity you have in your house.

Appreciation

Real estate historically appreciates in value. The national average is a 3 percent per year increase. One of the reasons that real estate appreciates in value is that the cost of building new houses keeps going up. The raw materials required to build a new house keep going up in price so it’s more expensive to buy a brand new house than an existing house. That creates demand in the used housing market which keeps the prices increasing.

Another reason that real estate increases in value is because land is a fixed commodity and as less of it is available the demand increases. This type of appreciation doesn’t happen everywhere but usually in places where it’s desirable to live. Perhaps a large manufacturing plant is built far away from an existing city. People who work at the plant want to live nearby, so they start to purchase or rent houses near it. A submarket is created with demand and the prices of real estate in that submarket will appreciate in value.

You should not depend on or expect appreciation to create a capital gain or grow equity. Appreciation is a nice benefit to owning investment properties but you can’t control it. If you buy an investment property because you think its value is going to appreciate you are speculating, not investing. Depend on other factors you can control like capital gain, cash flow, leverage, and equity growth.

Taxes

Perhaps because so many lawmakers own real estate the tax laws for real estate investments are favorable to investors. Whatever the reason, the truth is that the tax code encourages real estate investing.

You will need to consult with a tax expert to know exactly what you can do in your particular situation because as you know, the tax code is very complex. That being said however, the advantages we are going to discuss are generally applicable.

Many of the expenses that you incur operating your investment properties can be written off the profits before taxes are calculated. This reduces your profits for tax purposes and in many cases can eliminate or almost fully eliminate taxes on the income.

Another tax advantage with rental properties is depreciation. Even though real estate typically appreciates in value, the tax code is written so that you can depreciate the actual building (house). The amount of depreciation is calculated according to IRS rules, and that amount is deducted from taxes owed reducing your tax burden.

When you sell a property and the unrealized capital gains become realized, the capital gain and recaptured depreciation is taxable. However the tax code allows the deferment of paying the tax if the capital gain is used to purchase another like-kind property. The effect of this is that as long as you keep the capital gains invested in real estate you don’t pay a tax on the gains. That gain keeps working for you without being taxed during the process.

The tax benefits to real estate are real but can be complex. It is recommended you research the IRS web site (www.irs.gov) to gain basic knowledge and then consult with a tax expert throughout the process so you apply the rules properly.

Comments

  1. I think Damon has a good potential for his own radio show, on this topic.

    John.

  2. Well put and very clear.

    Most people are so locked in to speculation (buy low sell high model) that they don’t even realize how real investing works. I think this clears it up.

    Thanks to Damon!

    Sincerely,
    Steve

  3. I was fortunate enough to be asked by damon to read the manuscript and offer editorial commentary. I tell you what ended up happening – was I actually was blown away after reading familiar concepts in a clear and refreshing way – that spurred me to action! I now am an equity partner in two multi family deals and I have two sf houses under contract. Thank you damon for writing such a great book!!

  4. I have a comment about one of the items:

    The numbers look like this:

    Total annual cash flow: $24,000/mo ($200 * 12 * 10)

    Either the cash flow should be $2,400/mo (not $24,000/mo) or drop the “/mo” and leave the $24,000.

    All of the numbers are correct; however, as it is stated, it intimates that the investment would cash flow $24,000 per month if one reads the “/” as “per” instead of “divided by”.

    Just a suggestion on clarity. Easily, I could be reading it wrong.

    Otherwise, this is one of the most articulate pieces I’ve ever read on the subject. I can’t wait for the release of the book. Bill Edwards.

  5. Damon Janis says

    Thank you Bill for the correction (I’ve updated the manuscript to take off the /mo — it should be $24,000 since it’s the annual cash flow).

    I’m so glad you found the chapter explained the subject material well.

  6. Judith Z. says

    Thank you, Damon, for making the complex so simple to understand. Whay would anyone not use real estate investing to build their personal wealth so that they can afford to do the things in life that are important to them?

  7. This is great!! A very clear articulation of real estate concepts. This will be a primer, Real Estae 101, if you will. Just think of all the people that really need to read and understand this!! Every teen ager should read this.

  8. Amber FitzPatrick says

    Damon I must admit I put off reading this article until now because “I didn’t have the time.” To my surprise this was such an easy read! You’ve definitely left me wanting more and I look forward to reading Financially Free in its entirety!

  9. I’m a brand new member to LSU, but really enjoyed this article. I’ve been reading as much as possible since I signed up a few days ago.

    I have two questions:
    1) Aren’t realtor fees and closing costs also major factors in capital gains.
    2) If you refi to capture equity, don’t you also have refi costs.

  10. Matt,
    1. Yes. However, many of us sell our own property and save massive amounts that way. The bigger cost is tax and that is avoided completely by the 1031 Exchange.
    2. Yes. Part of doing business. Shop at least 3 banks and get your best deal. Lines of credit from banks are great too and carry almost no costs by comparison.

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