1) Cash Flow
Cash is king and this surely rings true for real estate. Most people get involved in rental real estate as a way to replace their earned wages with “passive” income. The truth is, it’s generally not as passive as you might think. There’s a lot of work that goes into finding, funding, and managing properties. This is especially true if you are in a hot market with lots of competition. But the payoff to putting in the work and acquiring the right property is that it provides a continuous stream of income that should grow over time.
That additional stream of income can slowly but surely replace the income from your earned income job, or can be used to purchase additional property (most of us would encourage the latter). Every market offers different metrics as far as what types of returns you should realistically anticipate. That’s why it’s really important to have clarity on what your overall investing goals are, and make sure the market(s) you are investing in align with those goals.
Appreciation is a term most often associated with single family homes, but it also applies to the multifamily space. The value of a MF property is not based on comparable sales (although you definitely want to know what similar properties are trading for). Instead, the value is based off the NOI, or Net Operating Income. We will get into defining key terms such as NOI later on in this educational series, but for now just know that it’s the simple calculation of Income minus Expenses.
As an investment property, potential buyers do not care what the apartment complex down the street sold for, they want to know the income this property is generating. Essentially, that comes from rent. And what do rents do over time? They go up. If you’ve ever been a renter you can relate to looking at your lease renewal and wondering why your rent is going up $50 or $100. Even when there are little to no improvements made to your unit or the complex as a whole, there is typically a continual rise on rents over time.
Again, this is going to be market and owner specific. However, as a general statement it’s fair to assume that the rental rate on a multifamily will rise over the course of a hold period, therefore raising the overall value of the property.
This is the main reason we are so bullish on multifamily real estate over the stock market. There are several reasons, but let’s keep things simple and start with leverage for now. Leverage is simply using borrowed capital to purchase larger properties and increase potential profits. Simply put, it’s using other people’s money to make money for you. Say you find a good deal and have $100,000 to invest. If you were to get a bank/lending agency to bring 75% of the table (which is reasonable), that would allow you to purchase a $400,000 property. What if you had two partners who also brought equal capital contributions? At that same 75% LTV you are now looking at having the purchasing power of up to $1,200,000. I’m not saying that it’s go big or go home. There are properties of all shapes and sizes that provide great returns. But as a general rule, when you get into larger properties you can reap the benefits of the economies of scale.
Over the years to come the property will theoretically increase in value. Paying down the debt service and increasing rents, either naturally or through forced appreciation, will create a larger overall value of the property. Many investors choose to refinance their properties after a period of time and cash out on some or all of the equity. At that point you still own the property and enjoy the cash flow, continued appreciation and tax benefits, while no longer having any of your own money actually tied up in the deal. With the cash out refinance, you can then “recycle” that money into another cash flow producing asset. This is one of the many ways wealth is created in real estate.
Try asking your customer service representative at Fidelity or Charles Schwab about how you can create a velocity of money in your brokerage account….and please feel free to report back about how long the awkward silence was on the phone.
4) Tax Benefits
One of the most incredible and underrated forms of wealth creation through real estate lies in the tax benefits. Rental income is not viewed the same as earned income in the eyes of the IRS. Rental income is not subject to the same social security and Medicare taxes that we are all accustomed to coming out of our paychecks. Depending on whether you’re employed or self-employed, you could be paying 7% to 15% toward this FICA tax on your hard-earned income. Also, there is a beautiful tool in the real estate investing toolbelt called depreciation. With depreciation, the IRS allows you to deduct the cost of business items that have a “shelf life”. This can include items such as appliances, flooring, roofs and the building itself.
The 1031 Exchange is another powerful strategy that creates and protects your wealth. When you sell a rental property you typically have to pay capital gains tax on the profits incurred from the sale. The 1031 Exchange allows you to put those profits into another property and defer paying taxes on them. If you were to keep deferring the taxes by continuing to roll your profits into the next real estate deal, you could in essence defer the taxes indefinitely. If you were to pass away, the taxes would not be incurred by whoever inherits the property. They would essentially vanish.
There are several other tax benefits that could be discussed here. We wanted to just share a few of the big ones we really love.
Hope this information was helpful and please don’t hesitate to reach out if you want to discuss more or have additional questions!