Investing 101 Chapter3
Chapter 2 covered Real Estate Investing.
HOW TO BECOME WEALTHY
Invest Faithfully
We have already discussed this principle briefly, but it bears repeating. Faithful, regular investing is the single most important principle to becoming wealthy. Budget a portion of your income to put aside for investment. Make the commitment to yourself and stick to it.
Leverage
Real estate allows you to control an asset valued at many times your initial investment. Typically you can purchase an investment property with a down payment of 10 – 40% of the purchase price. Your return, however, is based on the full value of the investment. Let me illustrate this by way of example: If you have $100,000 to invest and you purchased stock in XYZ Corp. you would exchange $100,000 cash for a number of shares of stock. If the value of your stock went up 5% per year, after the first year your investment would be worth $105,000. Your return would be $5000 or 5%.
If you took this same $100,000 and invested in income-producing real estate, you could purchase a property valued at about $322,000. You would put down 30% ($96,650) and you would have some fees, usually 1% of the loan amount, involved with obtaining the loan ($2,254) and some miscellaneous fees involved in conducting the transaction (Let’s say $1,146 to give us a nice round number to work with). So your total investment would be $100,000. If the value of your building goes up 5% per year, after the first year your building would be worth $338,000. Your return would be $16,100. That is a 16.1% return on your initial $100,000 investment.
Appreciation
Appreciation is the growth in value of an asset. In our example above the appreciation rate was 5%. Appreciation can be affected by the desirability of the surrounding area and external events that the investor has little control over, like new government regulations or new development in the area. The investor can also influence appreciation internally by making improvements to the property to make it more desirable to a potential buyer.
Cash Flow
When properly structured, an investment property can produce enough rent to cover the expenses of the property and mortgage payments. If there is more income than expenses this is referred to as “positive cash flow.” If the expenses are more than the income, we refer to this as “negative cash flow”. Obviously positive cash flow can put money into your investment program, but there are times where negative cash flow may be justified when the appreciation and/or other benefits more than offset the negative.
Using the same building in our example above, let’s assume that the building is a four-plex with each unit renting for $650/month.
Scheduled gross income would be $31,200.00 ($650/mo. X 4 units X 12 months)
Allowing a 5% vacancy rate gives a rental loss of $1,560.00
If annual expenses equal to $3,000.00
And the debt service is $19,888 (Assume a 7% interest rate / 30 year Amort / 5 year call)
Our positive cash flow would be $ 6,752
That’s $6,752 cash in the first year that you can re-invest into your wealth accumulation program. If you look at this as a return on your initial $100,000 investment, you can see that this is a 6.75% return. If you add the 16.1% return from the appreciation, we now have a return of 22.85% on our initial investment of $100,000.
Tax Advantages
Investors in income-producing properties enjoy some tax advantages that may not be available to others. While I don’t believe investment decisions should be made solely on tax consequences, I do believe you should take advantage of any legitimate method of reducing your tax liability that is available to you.
Unlike interest paid on consumer debt, mortgage interest is 100% deductible.
Another important tax deduction is depreciation. The tax code allows you to deduct depreciation every year against the income of the property based on the assumption that the improvements (not land) have a useful lifespan after which they are of no value.
These two deductions combined can amount to a significant tax savings. In our example we would have mortgage interest in the first year of $17,634 that could be deducted. The depreciation, 27.5 years on $273,700 would be $9,953 (Remember only the building can be depreciated, not the land) giving us a total deduction of $27,587. If you are in the 28% tax bracket, that would translate to a potential tax savings of $7,724.36.
The tax savings equates to 7.72% return on your initial $100,000 investment. Added to the 16.1% return from appreciation and the 6.75% cash flow return, we now have a total return of 30.57% on your initial investment of $100,000.
The depreciation taken decreases the basis and must be considered as gain when the property is sold, but with a properly executed 1031 exchange, you can roll the gain over into the basis of the new property with no tax liability until the new property is sold. This process can be repeated indefinitely. There are obviously conditions to be met and you should consult your financial advisor or accountant to see if a 1031 exchange is right for you, but this is another excellent tool that can be used in your wealth accumulation program.