In this article, I’m going to outline why real estate is one of the best ways to build wealth.
Over the past 200 years, investing in real estate has made more than 90% of the world’s millionaires! For the average investor, real estate provides the most tangible way to create significant wealth. Let’s take a closer look at how real estate is generating that wealth.
Cashflow is the money left over from the rent collected every month after paying all expenses. Expenses include the debt service (paying the mortgage) and all the monthly bills such as utility, insurance, property tax… When the property pulls in more income than all the expenses carried to own and operate it, the property is “cashflow positive”.
Cashflow is also a safety net from what happens in the market. While betting only on appreciation to make money is speculative, having a property that provides monthly positive cashflow will keep the investor safe during a downturn.
Appreciation is the rising of home prices over time. It occurs on the long run usually when a property simply increases in value over time. There are different factors that cause appreciation: demand getting higher while supply is not increasing, inflation, rising economy… I wouldn’t necessarily rely on this one when assessing a property but I treat it as icing on the cake. It is a huge factor in wealth creation as it can have a big impact on the ROI. The combination of appreciation and leverage offers huge returns.
- Property purchase price: $200,000
- Downpayment: 20% ($40,000)
- Appreciation over time: 20% ($40,000)
- New property value: $240,000
Results: You actually doubled your investment which translates to 100% return.
Mortgage Pay Down
Mortgage pay down, also known as principal reduction, is the repayment of the mortgage that was granted to purchase the property. As the rent covers all the expenses including the mortgage, the loan gets paid overtime. A portion of that repayment goes to paying the interest charged by the lender but the remaining goes toward the principal. While at the beginning most of it is going toward the interest, it is hardly making a dent into the loan balance. As time goes by, a larger portion of the payment goes toward the principal. This one creates wealth in the long run as this is money going into the owner’s pocket.
Tax benefits is another profit center which happens in the backend, on your tax return. Real estate is known for having favorable taxation. In fact, you can deduct a lot of expenses incurred while owning a property. For instance, you can claim the interest of your mortgage, any repairs and maintenance, your property tax, insurance….
It also includes depreciation which is the ability to write off part of the value of the property itself every year. Properly used, it can significantly reduce the tax burden on the income made. Basically the government considers the properties you own to be slowly wearing down over time, and much like equipment for a business you own, you’re allowed to write off that wear and tear.
As always, make sure to consult a CPA for the details on these tax benefits.
Additional Profit Centers
Those are the main profit centers that are available when investing in real estate. You could also consider the following additional profit centers:
- Instant Equity: when you buy a property below market value, you realize an instant profit of the difference between the market value and the purchase price.
- Forced Equity: this occurs when you rehab a property to make it worth more. Unlike appreciation, it will give you a certain degree of control over increasing the property value.
- Leverage: the ability to buy and control an asset with investing much less money than its value. Real estate offers incredible terms compared to any other kind of loan. Interest rates are very low, down payments can be 20% or less and loans can be amortized easily over 30-year periods.
- Reinvesting Your Equity: if you don’t sell the property, you may refinance and pull out some of the equity to buy more properties
Best way to build wealth?
All those profit centers are the reason real estate has made so many millionaires over the years.
Many people understand that real estate can create wealth, but not everyone understands why. I hope this gives some clarity on why investing in real estate can grow your wealth so effectively.
There are many ways to build wealth, but real estate might be the safest, steadiest and simplest way to do so. That is why I personally think it is the best way to build wealth.
What profit center do you find the most appealing? Let us know in the comments!