Let’s Talk Real Estate – October 2016
Do you have enough for retirement? Financial planners usually use the “25 Times Rule” to determine how much a portfolio should be worth for someone to safely retire. If you need $50,000 a year to live on when you retire, then, using the “25 Times Rule” you should have $1,250,000 in stocks, bonds and mutual funds. Then, at retirement, financial planners begin liquidating these assets using a “4-Percent Rule,” which simply means they liquidate 4 percent of the portfolio each year until it is down to zero after 25 years. If you retire at 65, you better hope you don’t live past 90 or you’ll be broke.
Compared to investors who rely on the stock market to accumulate assets for their retirement, real estate investments take a different approach. If you accumulate $2,800,000 in income-producing real estate, it will pay $50,000 a year in income and continue to appreciate in value over the years, not only covering you indefinitely but also leaving you something to pass on to your children.
Here’s the interesting part, it only takes $700,000 in investment capital to accumulate $2,800,000 in real estate assets. By comparison, it takes about $900,000 in stock investments to achieve a $50,000 per year annual income, assuming that during 30 years of investing both types of investments yield a 4 percent return.
Real Estate has many advantages over investing in stocks, bonds or mutual funds. Real estate offers predictable cash flow; it appreciates in value, thus keeping up with inflation; it provides a higher return because of positive leverage; and it offers equity growth through debt reduction. During retirement, real estate is a self-sustaining asset while stocks are a self-liquidating asset. Which would you prefer, a self-sustaining asset or a self-liquidating asset?
Ten reasons to invest in real estate:
- Real estate has a predictable cash flow—Cash flow is the net spendable income derived from the investment after all operating expenses and mortgage payments have been made. A good real estate investment should provide you with 6% or greater cash flow.
- Real estate appreciates in value—Since 1968, appreciation levels for real estate have been 6 percent per year, including during the downturn in the economy beginning in 2007, according to the National Association of Realtors.
- Real estate can be leveraged—The most important advantage of real estate investing is LEVERAGE! It is the use of borrowed capital to increase the potential return of an investment. In real estate transactions, leverage occurs when a mortgage is used to reduce the amount of investor capital required to purchase a property. The annual return on a $200,000 property with a $20,000 net cash flow purchased with cash is 10 percent. If 75% of the money required to purchase the property is borrowed, even factoring in the cost of making the mortgage payment, the annual return more than doubles to 22 percent (assuming a loan of $150,000 is amortized over 30 years at 5 percent interest).
Once you have built up an equity position in an investment property, you can leverage that investment for cash in one of two ways: Secure a second loan against the increased equity or refinance the original loan amount plus the increased equity.
- Real estate provides equity buildup—Most real estate is purchased with a small down payment with the balance of the money being provided through debt financing from a lender. Over time, the principal amount of the mortgage is paid down, slowly at first, and then more rapidly toward the end of the amortization period. This principal reduction builds equity.
- Real estate is improvable—One of the most unique and attractive advantages of real estate is that it is improvable. Because real estate is a tangible asset made of wood, brick, concrete and glass, you can improve the value of any property with some “elbow grease” and “sweat equity.” Whether the repairs are structural or cosmetic, do-it-yourself or hire someone, the principle is the same.
- Real estate coincides with retirement—When real estate is purchased, the cash flow is lower and the principal reduction on the mortgage is less. Over time the mortgage is paid down, or paid off, and the cash flow increases. In some respects, it’s a forced savings program, yielding a greater amount as time goes by which is a perfect investment for retirement as it increases in cash flow down the road.
- Real estate is tax deductable—Tax codes allows various deductions for the normal expenses incurred in owning real estate, such as property upkeep, maintenance, improvements and even the interest paid on the mortgage. The deductions can offset income and reduce your overall taxes.
- Real estate is depreciable—Depreciation is a non-cash expense permitted by tax code that depreciates in value of your investment property over time. However, the value of your investment property actually appreciates. The depreciation deduction allows a real estate investor to generate a larger positive cash flow while reporting a lower income for tax purposes. This creates a higher return than you may initially realize.
- Real estate has a lower tax rate—If your investment property is sold after a year, the gain is subject to capital gains tax rates which, depending upon your individual tax bracket is generally 15% or 20% which is usually less than one’s personal tax bracket.
- Real estate gains are deferrable—Our tax code, under a 1031 exchange, permits the gain on the sale of an investment property to be transferred from the property being sold to a new property being purchased, hence deferring the payment of any tax on the sale of the property.
There is one final advantage to a real estate investment—it is understandable and easy for most everyone. It’s easy to purchase, it’s easy to finance and there are no insurmountable financial barriers to enter. It’s easy for most investors to improve their properties and it’s easy to use the tax advantages. While Wall Street is becoming more and more of a mystery and becoming the game of financiers, real estate investing is looking better and better.