Have you heard stats such as “80% of millionaires attribute their wealth to real estate”? Or heard stories of living the good life off passive cash flow from rental property? Combine this with the recent years of unpredictable, disappointing stock markets, and you get masses of people realizing they have no control over many of their investments and therefore their life savings. Tired of blindly following the crowd of 401K stuffers, many have started looking at why so many wealthy people own real estate. In this article, I will break down the numbers in the simple yet rarely talked about truths behind the wealth building abilities real estate carries.
Who doesn’t love to focus on the wealth and freedom real estate can give you? We all love it so much, we forget to explain how it does this. This void in education leads people jumping in not realizing that even some investment strategies within real estate do not carry the benefits of others.
Going to meet ups, listening to podcasts, or reading articles, you frequently hear about people building wealth and the successes they have accomplished through owning investment real estate. What we forget to ask is why and how owning investment real estate is able to make this happen so much better than other investment strategies, including flipping, stocks, private lending, and any other form of investing. In this article, I will answer that very question.
Why I Focus on Multifamily
When it comes to real estate investments, I focus in multifamily apartment complexes because of the control it provides in determining the investments results. Some of the most powerful factors in real estate are control, debt (leverage), and taxes. For the average investor, leverage is commonly used in real estate, but not in stocks or private lending. In addition, the IRS and owners of investment rental property might as well be best friends because the IRS has made so many rules to benefit us.
There is a lot of useful information packed into this article. You will have to read this article slowly and maybe even a few times. If you don’t know a term, stop and look it up. Stop to understand the math. Even though there is a lot of math, it’s only addition, subtraction, multiplication, and division. I actually wrote this article on my iPhone using the iPhone calculator, so don’t let the math overwhelm you. Once you truly understand all of the words and math behind it, you will see how simple it really is to build wealth in real estate and why our wealthy continue to attribute their financial freedom to real estate.
The best way to illustrate the truth is through math and examples. Rather than look at the same old surface results, we are going to drill way down into why all these millionaires attribute their wealth to real estate — and specifically multifamily and other commercial real estate investments.
Today, You’re Buying an Apartment!
You put a $200k down payment on a $1M building at a 8% capitalization rate (very achievable). This leaves you with $80k net operating income ($1M x .08). When you borrowed the $800k from the bank, they lent it to you at 4% interest with a 30-year amortization. This means your year one mortgage payments equal $45,832 ($31,744 interest, $14,088 principal), leaving you with $34,168 in cash flow ($80,000 – $45,832) or a pre-tax cash on cash return of 17%.
But wait, there’s more!
So if you cash flowed $34,168, do you pay tax on $34,168? NO! Another beauty of real estate and leverage is the depreciation tax benefit. This is one the benefit the IRS has given to their buddies who are real estate investors. Even though you only put 20% of the $1M into the property, you get ALL of the depreciation benefits.
Apartment buildings are depreciated over 27.5 years, which means you get to depreciate the building’s value. The building’s value does not equal the property value because the building sits on land, and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value that is allocate to land value is 20%, or in this example, it would be $200k. This leaves you with $800k of building value to be depreciated, so $800k/27.5 = $29,090.
What does this mean? It means you barely pay any tax on that $34,168 cash flow you made on the building. You actually only have a taxable gain of $19,166 ($34,168 cash flow + $14,088 principal portion of your mortgage payment – $29,090 depreciation). We add back the principal amount of your mortgage payment because it is not a tax deductible expense and subtract out the deprecation we listed above.
Since you were able to put $200k down on a property, I’ll assume you’re doing pretty well financially. Because of this, I’ll even venture to guess you’re in a 35% tax bracket. Since your tax bracket is 35%, the taxable gain of $19,166 would result in cutting a check for $6,708 to the IRS, leaving you with $27,460 ($34,168 – $6,708). This means your after tax return is 13.7%.
This is where most people shut off the brain and say, “My financial advisor says I can earn 8% in a mutual fund, and those have no tenants, no managing the property manager, no headaches. That peace of mind in itself is worth not owning real estate, right?” NO, not true at all! There are more major pieces to this puzzle that the wealthy use that so many that give up at this step never see…
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