By Jared Paul, CFP, CIMA
Real estate is a form of investing with potential for a large return on your money, though many people may not be aware just how great of an option real estate investing actually is.
Andrew Carnegie was one of the most successful businessmen ever. At its peak, his fortune was worth over $300 billion (In 2007 dollars adjusted for inflation). He is attributed with saying, “90% of all millionaires become so through owning real estate.” Mr. Carnegie was alive during most of the 1800s, and passed away in 1919. No doubt, times have changed a bit since then. However, real estate is currently among the top 10 creators of billionaires.
Real Estate Allows More Control Over the Outcome
In addition to it being one of the top ways to amass wealth, real estate is one investment where you can have much more control over the outcome. If you invest in a stock, bond or even a mutual fund, you have less control over what will happen. If you invest in a company’s stock and a report comes out about how the CEO approved illegal activities and now the company is up to its eyeballs in lawsuits, that stock price is going to plummet, and it's completely out of your control. You are just a spectator, watching from the sidelines.
With real estate, you get to play an active role in how that investment is going to perform for you. If you want to increase the value of the property, there are specific ways you can do this, including through renovations, increasing income for a rental property, and even lowering expenses.
There is a simple acronym to remember: IDEAL. The letters stand for income, depreciation, equity, appreciation and leverage. Let’s explore each one and why they are so beneficial.
Real Estate can help create a stream of income.
If you own several multi-family buildings, each one of the units is creating an income stream for you from the current tenants. They pay rent each month, and that monthly income flows to you. This point is crucial because of what it represents in the long-term. Most people are focused on saving for retirement, which means you are trying to save up enough money to one day replace the income from your job and stop working.
Each time you purchase real estate that pays you an income, you move one step closer to your goal of income replacement. You just have to get to a point where the income your properties are paying you is large enough that you don’t have to work anymore. People work for years to build up a retirement nest egg, then they aren’t sure of the best way to turn that nest egg into an actual income stream. Real estate helps to alleviate this issue. (For related reading, see: Real Estate Rentals for Retirement Income and Building Wealth.)
Depreciation is an accounting method that allows you to deduct the value of an asset over its useful life.
As an example, imagine if a farmer bought a tractor for their business. That tractor is only going to last for a certain number of years, then the farmer needs to purchase another tractor. The IRS allows the farmer to deduct a percent of the cost of the tractor from their taxes each year as a business expense.
The magic of real estate is you also get to depreciate the value of the property when it comes to your taxes, but over time real estate actually tends to go up in value and not become worthless, like a tractor. Because of this, you get to take a tax deduction to offset the income the property is producing for you, helping to save money over time. (For related reading, see: Use Real Estate to Put off Tax Bills.)
Each time you make a mortgage payment, part of it goes toward paying interest on the loan and part goes toward paying down the principal value of the property. With each payment, you own more and more of the property. If you own rental properties and have purchased a good investment, the income from the rentals will pay the mortgage payment, and there will be left over money for repairs, maintenance and more. At the end of the mortgage period you will own the entire property, and your tenants will have paid for the majority of the cost.
In addition to the build-up in equity from paying down the mortgage, you will also benefit from the increase in property value.
Over time, real estate prices tend to go up in value. Every region of the country is a little different, but regardless of high-appreciating areas like major cities, inflation alone pushes up the costs of most things over time, including real estate.
When evaluating a potential investment, look at the appreciation potential, but think of it as icing on the cake, don't plan on it. This way, even if the property doesn’t go up as much as you planned, the investment should still be a good one. (For related reading, see: How You Make Money in Real Estate.)
Leverage is the concept that you can pay for something without coming up with the full cost. For real estate, you can use leverage by taking out a mortgage to buy a property and only putting down a fraction of the total cost. Even though you only put down a small portion of the purchase price, you are still entitled to all of the benefits. You get to keep all of the income generated, all of the equity build up, all of the appreciation of the property, and you get to utilize all of the tax write-offs.
You simply cannot do this with most other investments. The accessibility of leverage in the real estate industry is what helps you start investing before amassing a fortune. You can even use an FHA loan to buy a four-unit building with a down payment of only 3.5% of the total purchase price.
Real Estate Investing Isn't for Everyone
Despite all of the benefits, investing in real estate isn’t for everyone. To do it properly, you do need to put in some extra effort. But for anyone interested in building wealth, real estate can be one of the best ways to do it.
(For related reading, from this author, see: 7 Lessons Learned About Investing in Real Estate.)
This article was originally published on Investopedia.