The real estate market has certainly been rather odd over the past year or so. Many (including myself admittedly) expected it to dip around the time the pandemic started. But that has not (as of yet) come to pass. It still might and sooner or later real estate prices will certainly decline again. But regardless of the ups and downs of the market in the short-term, when it comes to the long-term, real estate investment is, in my humble judgement, the best investment someone can make.
As my father once told me, “buy-and-hold real estate is the best way available for someone of modest means to become independently wealthy.”
And I wholeheartedly agree.
The reasons holding real estate long-term is such a good investment can be boiled down to a handy little acronym: IDEAL.
This is the positive cash flow that you get each month. While this is nice, many people get into buying rentals hoping that with “X rentals I won’t need to work anymore” or something like that. It generally doesn’t work that way. Cash flow is all well and good, but it takes a long time (if you use debt) to make enough with it to get by.
Cash flow is really just the cherry on top. But it’s important to have to make sure you can remain solvent.
Each year, the IRS considers a property’s value to depreciate. For residential properties, the property’s value goes from the combined purchase price and capital improvements down to zero in 27.5 years. For commercial, it’s 39 years. (Only the property value depreciates, the land value does not. The property’s value is usually assessed at 80 percent and the land at 20 percent.)
This means that the “losses” from depreciation can be counted against your positive cash flow. So if you made $10,000 in cash flow and your property depreciated $10,000 that year, your tax burden on that cash flow is zero.
Of course, that depreciation is just on paper. In reality, real estate tends to appreciate (See the “A” section). Now it’s true you will have to “recapture” that depreciation if you sell and pay taxes on the total sum that was depreciated. But at that time, you can also use a 1031 exchange to buy another like property and continue to defer those taxes indefinitely.
E: Equity Buildup
If you get a long-term loan from a bank (which you should), each month you make a payment, the principal balance goes down a little. The longer you hold the loan, the more of the payment goes to principal and less to the interest.
Real estate also generally goes up in value. Not always in the short term of course, but over the long term it will almost always go up.
When you combine appreciation with principal paydown, the amount of equity you have in a property begins to increase in a more exponential and less linear fashion.
One of the best parts of real estate is the ability to (wisely) use leverage. If you buy a property for $200,000 and get a $150,000 loan on it. And then the property goes up 5 percent to $210,000. You didn’t make 5 percent on your money, you made 20 percent. ($10,000 gain divided by $50,000 down payment.)
That is how you can substantially increase your wealth over a relatively short period of time.
But of course, leverage is a two-edged sword. If the property goes down 5 percent, you would lose 20 percent on your money. Luckily, you can alleviate this risk as well.
Unlike the stock or bond market where all the information on these assets is publicly available and it’s extremely hard to find a good deal, each house is a market in and of itself to a certain extent. Because real estate is comparatively illiquid, it can’t just be sold willy nilly like a share of stock can. This creates opportunities for investors to get below market deals by finding motivated sellers or value-add opportunities.
If you buy below market, you make money right off the bat. But furthermore, you insulate yourself from the risk of using leverage. If you bought the hypothetical property mentioned above for $160,000 instead of $200,000 and it went down even 10 percent to $180,000. You would still have $20,000 of equity and could sell without bringing any money to the table if you chose to.
For these reasons, I strongly believe buy-and-hold real estate is the best investment around and something you should strongly consider.