How Real Estate Makes You Rich
“Ninety percent of all millionaires become so through owning real estate.”
Andrew Carnegie (Industrialist and Philanthropist)
The secret weapon of the wealthy
You’ve probably brushed shoulders with a few wealthy individuals throughout your life. These are people who have mastered the game of money and have created generational wealth for their families. As I reflected on the encounters I’ve had with the wealthy, I couldn’t help but notice a common thread: they all invested in real estate.
Some happened to acquire multiple single family homes in the San Francisco Bay Area (well before the boom), others owned apartment buildings or shopping centers, but at the end of the day, they all chose to invest in real estate - “dirt, bricks, and sticks”. Even though I was able to identify the association between real estate & the wealthy, the conclusion I came to was wrong. I thought that real estate was reserved for the wealthy, an exclusive arena beyond the reach of the average person. In reality, however, most of these individuals were wealthy because of real estate - this causal relationship piqued my interest.
What was so special about real estate? What was it about this asset class that propelled these individuals toward a path of prosperity? What made real estate the perfect investment?
Read on, because in this blog post, we’ll try to break it all down!
Real Estate: A symphony of building wealth
The power of real estate lies in the multiple ways it’s able to make money for you, the owner. These different elements work together and blend to deliver a perfect (financial) harmony, almost like a symphony. Cash flow takes on the role of the steady rhythm section, providing a consistent stream of income. Appreciation adds the soaring melodies, with the value of properties rising over time. Loan paydown acts as the supporting bassline, steadily building equity and increasing net worth. Leverage emerges as the orchestra conductor, magnifying the impact of your investments by allowing you to borrow money to acquire properties, amplifying your returns. And lastly, all the instruments come together for the crescendo of tax benefits.
Let’s take a closer look at each of these elements.
Cash Flow 💵
In our last blog post, we talked about how the cash flow generated from real estate can accelerate your path to retirement. To recap, when you buy the right property, the rental income will exceed the expenses, resulting in positive cash flow every single month. I’ll dedicate another blog post on how to analyze a rental property, but let’s go over a quick example.
Scenario: Let’s say we purchased a 3 bed / 2 bath house for $100K (yes, these exist). We put down 25% ($25K) and we got a loan for the rest @ a 6% interest rate.
Cash Flow = Income - Operating Expenses - Mortgage
Income: $1,000 (how much the property rents out for)
Operating Expenses: $400 (property management, taxes, insurance, repairs, etc)
Mortgage: $450 (principal + interest)
Cash Flow: $150 ($1,000 - $400 - $450) each month
Cash on Cash Return: 7% ($150 * 12 months / $25K investment)
So in our example above, you would be making $150/mo or $1,800/yr from this rental property, which equates to a 7% return on your original investment of $25K. For comparison purposes, the same $25K invested in the S&P 500 (ticker: VOO), would yield around $33/mo or $400/yr in the form of a cash dividend (1.6% return). At this point you might still be unimpressed: “How am I supposed to achieve financial freedom with only $150/mo?”. To which I would reply: “You don’t”.
No one is saying you’re going to retire from the cash flow of one property. Real estate is a “get rich slow” game. The true wealth comes from long-term ownership of a portfolio of cash flowing properties. Another important thing to note about cash flow is that it increases over time. This is because as your revenue increases (rent), one of your largest expenses (mortgage) doesn’t change (assuming you have a fixed-rate mortgage). So that $150/mo in cash flow from that one property, is going yo look a lot different in 10, 15, 20 years and beyond.
And remember, this is only one of the ways real estate makes you rich.
Over the last 20 years, rent in the US has grown on average 3% to 4% per year. As the rents increase, profitability on your rental properties improve.
Appreciation (and Leverage) 📈
If you’ve been following the real estate market at all, you’ve probably seen headlines about the rising cost to buy a home. According to the Federal Reserve, the median price of a home in 2012 was around $250K. In 2022, just 10 years later, the price rose to $479K. Similar to rents, home prices have appreciated 3% to 4% on average for the last 20 years, and it doesn’t look like this trend is going to change anytime soon.
When the price of the property appreciates, your equity in the property (equity = the value of the property minus any outstanding debt) increases, which means more money in your pocket. You might be thinking: “3% to 4% appreciation is nothing, stocks are supposed to appreciate 8% to 10% per year!”. To that I would reply: 1) Very few stock market investors achieve the same returns as the market (see: panic selling), and 2) This comparison ignores the fact that leverage amplifies appreciation in real estate. Let’s paint this picture with an example.
Scenario: In the example above, we put down $25K to purchase a $100K house, and the bank gave us a loan for $75K (leverage).
After 1 year, the house appreciated 4%, and it’s now worth $104K
That incremental $4K is actually a 16% return on your $25K investment ($4K / $25K)
Caution: Leverage amplifies returns when the asset is appreciating, but it also amplifies losses if the asset is losing value
Why do the prices of homes continue to rise? To throw it back to economics 101, the answer lies in supply and demand. Everyone is always going to need a roof over their heads, and as population growth continues, demand for housing follows suit. On the supply side, there is an estimated shortage of ~5 million homes in the United States. During the great financial crisis in 2008, home builders stopped building completely. Even as the market recovered, and the demand for housing started to pick back up, the builders were slow to build. What’s resulted is a housing deficit that will be impossible to close for some time. People that buy and hold real estate over the long-term will continue to benefit from these supply and demand dynamics.
Housing supply in the US is at historically low levels. If the supply remains constrained, prices will continue to remain elevated.
Loan Paydown 🏦
Everyone is probably familiar with the concept of debt: you borrow some money to buy something, and you pay it back over time with some interest. Not all debt, however, is created equal. Real estate is often referred to as “good debt”. Why? Because although you borrowed 75% from the bank to purchase the property, you personally won’t be paying any of that money back - your tenants will.
When you rent the property out to tenants, the rent you collect will, in part, be used to pay the bank back. Every single month, your tenants are decreasing your loan balance for you. As your mortgage balance decreases, your equity is increasing, and eventually you will own this property free and clear. The combination of loan paydown and appreciation can result in serious equity buildup from long-term ownership of real estate.
You might ask: “Why would the bank lend so much money to buy real estate?”. First, the banks view real estate as one of the safest possible investments. They are quite confident that even if a borrower defaults on the loan and hands them the keys, that they can sell the asset and get their money back. Second, they make a ton of money on interest. Let’s break it down with our $100K house example.
Scenario: We get a $75K loan from the bank at a 6% interest rate to purchase the $100K property. Over the 30 year term of the loan, the bank will receive just over $162K ($75K loan amount + $87K interest). That is more than a 2X return for the bank.
The chart above illustrates a typical loan amortization schedule. In the early stages, your mortgage payments are mostly going toward interest. This is to ensure that the bank is making money on the loan. As the loan matures, however, more and more of your payments go toward principal, thus decreasing the amount that you owe the bank overall.
Tax Benefits 🇺🇸
(disclaimer: I’m not a CPA or tax professional, and this is not tax advice)
It’s not about how much money you make, it’s about how much money you keep. Someone who makes a $200K salary, but pays 50% in taxes is no better off than someone who makes $100K in real estate profits and pays 0% in taxes. The reality is that taxes will likely be the largest expense you incur throughout your lifetime, and you must educate yourself on how the tax code works in order to build lasting generational wealth.
The first thing to understand about the tax code is that it was written to benefit business owners and real estate investors. Why? Because the US government is trying to incentivize the behavior it wants to see. Individuals who create businesses stimulate the economy with innovation and job creation. Real estate investors create housing that is desperately needed (see: housing shortage). This is probably the most misunderstood thing about taxes. Most people think that if you aren’t paying taxes, you are doing something shady or illegal. While there is undoubtedly some of that happening, for the most part, people are just following the rules laid out by the IRS. If there are winners, there are (usually) losers. If the winners are business owners and real estate investors, the losers are definitely the traditional W-2 employees who pay an exorbitant amount in income taxes.
What are the tax benefits of real estate investing? Without getting too in the weeds (click on the links for more in-depth breakdowns), let’s outline the major benefits:
Depreciation: The government allows you to depreciate the property evenly (less the value of the land) across 27.5 years, and you can write-off that depreciation against any profits.
In our example of the $100K house, let’s say $20K was the land value
We can write-off almost $3K/yr ($80K divided by 27.5)
Since the property was cash flowing $2K/yr and we are writing off $3K/yr, the IRS would view this as a loss of $1K (even though we aren’t actually losing any money)
Depreciation allows real estate investors to take “paper losses” against real cash flow
1031 Exchanges: If you sell an investment property, you can defer paying capital gains tax, as long as you use the proceeds from the sale to invest into more real estate. You can also continue to 1031 exchange until you die and your heirs won’t have to pay the taxes (because they inherit at a “stepped-up cost basis”).
Cash-Out Refinance: If you have equity in the property, you can access it via a cash-out refinance. Since the government views this as a loan that will need to be paid back, the proceeds from the refinance are not taxable.
Caution: In order to successfully execute a cash-out refinance, you need to have a substantial amount of equity in the property. You also need to ensure that the cash flow from the property can service the new (higher) loan amount.
As boring as it may seem to most people, a strong grasp of taxes is critical to your financial success. The less you pay in taxes, the more you have to invest in assets (like stocks and real estate), which will accelerate financial freedom.
Wrap Up
The key to unlocking financial freedom is having enough passive income to cover your life’s expenses, and real estate is one of the most proven ways to do so. While not entirely passive (there is some work involved), real estate investing is certainly more passive than your 9-5 job. Regardless of what happens at your job, your rental properties are still making you money through cash flow, appreciation, loan paydown, and tax benefits. The wealthy have been investing in real estate for generations, and for good reason. Done correctly, a simple strategy like buying one rental property a year can yield tremendous results over the long-term.
At this point you might be pumped to jump into real estate, which is awesome. It’s important to note, however, that it’s not all sunshine and rainbows. Real estate investing comes with its own unique set of challenges, and as with all investments, it’s entirely possible to lose money. This shouldn’t at all deter you from getting started, but it should motivate you to get educated, so you can minimize risk where we can. Real estate investing and the path to financial freedom won’t be easy, but it will be worth it.
Stay committed to the journey, my friend. Your future self will thank you.
