Introduction to Benefits of Investing in Real Estate

In my last post, I talked about how real estate investing can yield amazing benefits for your financial portfolio due to cash flow, appreciation, tax benefits and the ability to buy below market value (and in some cases sell above market value too!). If you don’t remember, these were labeled:

1. Cash Flow
2. Appreciation/Inflation Hedge
3. Depreciation/Tax Benefits
4. Arbitrage

Today we will cover the last three of seven great benefits:

5. Leverage
6. Loan Pay Down
7. Control

I will show you how leverage can amplify many of the benefits that we have already discussed and then outline be advantages of loan pay down and control.

Advantage #5: Leverage

You may remember the stories of Archimedes, the famous Greek scientist and inventor. He talked about having a lever long enough to move the entire world. Leverage in real estate is primarily the use of other people’s resources to make your deals work more easily or more profitably. The most common form is to use a bank loan to purchase a house. FHA loans will allow a person to buy a house with only a 3.5% down payment. Conventional 30-year amortized loans typically require 20% down. This kind of leverage can have a huge benefit to a real estate investor when used wisely. When overused, it can also be catastrophic so some education is essential.

Leverage has the ability to multiply the benefits of an investment. Applying the principle of arbitrage, let’s say you get a screaming deal on a $120,000 house and you get it for $100,000. If you pay cash, then on paper you just made 20% on your investment of $100,000. However, if you only put down $10,000 to buy the house and used bank money for the rest, then you just made $20,000 on a $10,000, tripling your money. This same principle works for appreciation so if you hold a $100,000 property until it appreciates 20%, then the same number apply. So would you rather make 20% or 200% on an investment. Leverage gives you the choice.

Money leverage (using “OPM” for “other people’s money”) also allows you to build wealth much faster. If you have $100,000 to invest (keeping in mind that you need to hold money back for expenses and contingencies) then you could invest in one house for that amount if you paid cash or several houses if you get loans to finance your purchases. Building a portfolio of cash flow properties quickly makes a lot of sense as long as you buy in areas where the rental market is stable and the rent payments more than pay for the loan payments. There is a metric called “debt coverage ratio” which measures how much money you have left over after operating the property as compared to the loan payment. George Antone (fynanc.com) is a great teacher on the safest ways to utilize debt. He stresses that if you use too much leverage then you are subject to volatility of the market where if rents decrease you could be in trouble with covering the mortgage. Many longtime investors will use leverage to build their portfolio and then use the cashflow  from their properties to pay down the loans to increase their safety and their cashflow. You see, all these benefits have an interlocking way of strengthening each other. So now we will talk about loan pay down as another benefit of real estate.

Advantage #6: Loan Pay Down

Since we have already talked about the benefits of using leverage and cash flow in real estate, we can now talk about how these combine to generate one of the most powerful long term strategies with real estate. Once you have acquired rental properties and balanced the amount of leverage you need with the amount of cashflow that you have coming in to be comfortable, an amazing thing begins to happen. Your tenants start paying down your mortgages for you. Before their rent goes into your bank account, it pays the loan for the mortgage that you used to buy the property in the first place. Now you can let them pay down your mortgage. Isn’t it great to have other people buy your real estate for you? By buying right (right price, right property, right neighborhood, right financing) you can use the rent from your properties to pay off your mortgages. Each time a mortgage gets paid off, the cashflow increases, allowing you to pay off other mortgages faster. This is like the snowball effect that people like Dave Ramsey (www.daveramsey.com) teach about getting out of credit card debt. The same mathematical principal applies to real estate debt. The big difference is that properly balanced real estate debt is what Robert Kiyosaki (of Rich Dad, Poor Dad fame) calls “good debt”. It is the kind of debt that allows you to buy cash flowing assets that appreciate in value and pay down the debt so that you will be able to retire with a strong, simple and stable source of income and have assets that you can leave to your children, loved ones or favorite charities.

Advantage #7: Control of Your Asset

Imagine that you bought that you had bought that 100 shares of Google that we were comparing in the last post to a real estate investment. If you wanted to make more money from your investment, what could you do? If you did more searches on Google or bought more services from them, would it help drive up the price of your shares? Hardly! Similarly, if you buy a bond, there is nothing that you can personally do to increase the value directly. Most wall street gurus will tell you to balance your portfolio with a proper asset allocation to minimize risk but the fact remains that your investments are what they are and you can’t really control the price of any individual asset.

However, if you had a $100,000 house in the Midwest that was bringing in $900 a month rent, you have a lot of options for increasing the rent on the place. In fact, there is a great book by Dolf de Roos entitled 101 Ways to Massively Increase the Value of Your Real Estate without Spending Much Money that shows you how to do this. You could add a garage, another bathroom, another bedroom, add landscaping, storage space, a laundry room, anything that would increase the value of the property in the eyes of a tenant. And the simplest way to increase your rent is to build in an annual rental increase. It’s amazing the number of people who had told me that they haven’t increased their rent in years. They like their tenants too much (another great reason to hire a property manager so that you don’t fall prey to this sympathetic but ineffective practice).

The Bottom Line

So there you have it, my friends. Here are my seven reasons for loving real estate investing as a faster path to wealth building. It is not the sexiest way to get rich but it may be the most secure. Sure, doing million dollar deals or building a company from scratch may sound more impressive but tens of thousands of people just like you are taking advantage of these seven simple benefits every day to become wealthy. Holding real estate assets that provide monthly income, tax benefits and control give you a pathway to paying for your retirement decades sooner than the save-and-hope strategy offered by banks and Wall Street. I hope you will comment below and let me know what aspect of real estate investing is most interesting to you. Please get a hold of me at gary.peyrot@gmail.com if you have any specific questions. Thank you, and may God bless your success.

Gary