Real wealth through multi-family real estate
Why Real Estate?
If I look at all the investment choices out there, nothing builds wealth more consistently than real estate. That word "consistently" is important if you are a risk-averse investor. That's what I look for - high returns that are very safe. And if you're not sure about your retirement future, real estate can be a great choice to get you where you want to be. Here's the reasons real estate is so powerful and safe:
1. It's a tangible or hard asset
Unlike stocks or bonds, real estate is a tangible asset that investors can see, touch, and improve. This physical aspect provides security and control over the investment. Look, if you invested in companies like Research in Motion (the Blackberry devices) or Enron or Lehman Brothers, you know that stocks can end up worthless. With real estate there's land there...there's a building there...there's always going to be something of value there.
And if you study what the ultra wealthy do, they diversify and hold tangible assets. Real estate investments have a low correlation with stocks and bonds, making them an excellent diversification tool. Adding real estate to an investment portfolio can help reduce overall portfolio risk and increase stability.
2. Appreciation
Historically, real estate tends to appreciate over time. Appreciation, or the rising of home prices over time, is how the majority of wealth is built in real estate. While there are fluctuations, property values generally increase, allowing investors to build equity and potentially realize significant gains upon selling. If you've owned your own home for a number of years, it's likely the value is much higher than when you bought it. It works the same way with rental properties.
If you look at Edmonton house prices you can see some incredible gains, but what you don't see is catastrophic losses - because there are none.
Appreciation tends to move like this. Big jumps with periods of slower or no growth. We'll explain why in the Why Edmonton? section.
3. Leverage
I've seen articles where the author shows how the stock market beats real estate but their theoretical scenarios don't even come close to the real world. Here's what I mean.
Leverage in investing refers to the use of borrowed capital to increase the potential return on investment. It allows investors to control a larger position in an asset or investment than would be possible with their own capital alone.
In practical terms, leverage involves borrowing funds from a lender, such as a bank or a brokerage, to finance an investment. The investor then uses this borrowed money, along with their own capital, to purchase assets or securities.
The primary advantage of leverage is that it amplifies the potential returns on investment. For example, if an investor uses leverage to purchase a property with a mortgage, the property's appreciation will increase the investor's equity in the property. If the property's value goes up, the investor's return on investment is calculated based on the property's total value, not just the initial investment.
That's a mouthful. Let me show you with an example:
So back to the stock market vs real estate comparison article ....
The authors and some financial advisors will show that the stock market outperforms real estate, but that only happens when no leverage is used. Reality is leverage is almost never used by most regular investors in stocks, but almost every real estate investment does use leverage. Reality vs. theory. Most homeowners are familiar with mortgages and wouldn't consider them risky, unlike stock margins.
Rate of return is key to reach your goals and leverage helps us achieve that, so let's talk about the risk.
Leverage magnifies the potential risks associated with an investment. If the value of the investment decreases, the investor still owes the borrowed funds, which can result in significant losses. With stocks, there's a pretty good chance stocks may fall in the short term (and maybe even in the long term). You get a margin call when that happens and you have to pay or sell stocks immediately.
With real estate, even if house prices fall, you don't normally get a call from the bank asking you to sell or give them more money. Time is on our side with real estate. Even if you bought at the top of the market, chances are you won't lose money so long as you stay in the game long enough, it just may take awhile. Just look again at the Edmonton house prices chart.
The other way leverage can hurt with real estate is it's effect on cash flow. If rents are covering all your expenses, so you break even each month, an increase in interest rates that raises the mortgage payments might mean you have to pay money out of your pocket each month. Mortgages just by themselves add an expense each month that could mean you have to pay out of pocket if, for example, you had a vacancy. The impact is less with no leverage, but so would the rate of return be. We manage the risk by not over leveraging and keeping an eye on the economy, interest rate forecasts and by having a cash reserve to take care of these.
4. Loan Pay Down
Again, most homeowners already understand this. You bought your house years ago with a large mortgage and slowly paid it off. Not only did your house go up in value, but your mortgage may be a fraction of what it used to be making the value of your house the single biggest asset you own for many people. The difference is the tenants pay off the mortgage with real estate.
Picture this... you buy a $400,000 ($80,000 down and $320,000 mortgage) house and your rents cover your expenses. House prices don't go up at all for 25 years (not likely). At the end of 25 years you have an asset worth $400,000 with no loan. Earlier you start, the better.
5. Inflation
Real estate is often considered a hedge against inflation because property values and rental income tend to rise with inflation. As the cost of living increases, so does the value of real estate investments.
6. Cash Flow
Cash flow is the money you have left over from the rent you’ve collected after all expenses have been paid. Positive cash flow means you have money left over and negative cash flow means you have more expenses and have to pay out of your pocket each month.
Many people would like to see cash flow up there as #1, but when it comes to wealth building, it's appreciation and loan pay down that matter more. Still, positive cash flow is definitely a benefit.
My reason for putting cash flow lower down is because so many focus on this and, at the beginning, you may pass up great properties that have slightly negative cash flow. I'm OK buying a property that has negative cash flow so long as it's a good property because:
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I'm focused on appreciation, and
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Eventually rents should go up and I will be positive cash flow in the future
Let me put it another way... You can easily get most properties to cash flow, all you have to do is put up a bigger down payment. But as we saw in the leverage section, that will hurt your rate of return.
But.... there are many people who have several properties who live off the cash flow!
7. Tax Advantages
I am not an accountant; just so you know. Let me show you how real estate can make you pay less taxes and have more money. This one may be hard to follow for some, who also are not accountants, but bottom line is tax laws favour real estate owners.
Remember that $400,000 house you bought? To keep this example simple, let's say the mortgage is paid off and you are cash flowing $2,000 a month into your pocket. That $2,000 you have to pay taxes on.
So what you do is take out a new mortgage on your property for $320,000. At 5.5% interest that means a mortgage payment of almost $2,000 a month which wipes out your cash flow (so now you don't have to pay taxes on it). But guess what?
That $320,000 goes into your bank account and it's tax free! "Why is it tax free?", you ask. It's because you are borrowing the money from the bank. It's not income. So now you have zero cash flow and $320k. You could buy another property, go on a tropical vacation and still have lots left over. How would that impact your retirement?
There's also other tax advantages like depreciating the building, that give you more tax write offs, but we're really getting into the weeds and more into an accountant's wheelhouse.
8. Social & Environmental Benefits
As a landlord or a developer, you have choices on how you build and how you treat tenants. You can build or renovate with more environmentally friendly products and you can do what we like to do, which has been termed "densification", which means putting more units on a piece of land that traditionally only held one. This means there is more land available for other uses, which is a good thing.
With tenants, you can provide good housing at reasonable rents. It's a choice. You don't need to be a slum lord to make good returns. Larger developments are even putting on classes and other events that help their tenants.
Making money in real estate also attracts developers, which creates more housing. That's a good thing, too.
11. Active or passive options
With real estate, you have the option of doing everything yourself, doing lot's of it yourself but hiring people to do other parts, and doing none of the day to day work yourself. The first two involve a lot of work and can make you more money - if you know what you are doing.
On the other hand, just being a real estate investor, similar to investing in mutual funds where you just contribute money and it's all "hands off" or passive for you, can still produce great returns.
If you're familiar with Robert Kiyosaki's Cashflow Quadrant, you'll remember you want to be in the Business Owner or Investor quadrants. Many rookie real estate investors get into the Self Employed quadrant.
10. Other Benefits
There are more benefits that I'm not going to get into here. Really, they are minor compared to the ones above.
Like I stated in the beginning of this lesson, "Nothing builds wealth more consistently than real estate"! Homeowners know this already, but it is not without risks. Risks can be minimized a number of ways and I want to cover some of that in the next lesson.