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The Three Powerful Tools of Real Estate Investment

Real estate is the most powerful investment vehicle that exists. I know that’s a bold statement, but a convincing argument is easily made to prove my point. I’m not talking about your home, which most people believe is an investment. To be sure, your home enjoys features of a true investment, but the biggest benefit is living in it, and the capital gain from a sale down the line is more than offset by expenses along the way, including mortgage interest if any. That automatically puts it into a non-investment category. Here, I am referring to buying property exclusively for investment purposes.

There are three huge benefits afforded to real estate investments that typically don’t occur in other investments:  1) Leverage, 2) Depreciation and, 3) Loan Interest Deduction.  These accomplish very powerful results for income sheltering and equity appreciation. The compounding of these produces returns that dwarf stocks and bonds.  Running a successful business would be the only way to beat it, but that is accompanied by greater risk and a lot of work.

Let’s explore an example to illustrate what I’m talking about. An $80,000 equity position in a $400,000 multifamily property increases by 58% over a five-year period to $126,400 with market appreciation at 4% per year and a conventional 30-year note. This property would earn $32,000 at the prevailing 8% CAP rate ($400,000 x 8% = 32,000). The CAP rate includes all expenses except depreciation and interest on the mortgage. Deducting depreciation of $10,256 per year and interest of $12,490 per year, the taxable income shrinks to $9,254, resulting in a net after-tax income of $29,687. Out of that, the loan principal must be accounted for—$7,418 per year (averaged over five years), leaving the investor with $22,269 of after-tax cash flow per year. So, adding all this up translates to a five-year return on investment (ROI) of $157,745 ($46,400 market appreciation plus $111,345 after-tax income), a whopping 197% ROI on the original $80,000, or 39% after-tax per year!

Every time I go through this exercise, I keep checking my numbers thinking that it can’t be right, but it is right! Where on earth will you find that kind of after-tax return? You can get lucky with an Apple type stock, but market volatility and uncertainty about any paper investment make conservative investors very happy with 8% or 10% before taxes.

The above scenario uses conservative parameters. A higher CAP rate will bring in more income relatively but may require more capital expense, and a lower rate of market appreciation because of a poor location. But, in general, these principles work across all income real estate types. I like multifamily property because it has the lowest risk of vacancy—everyone always needs a place to live, despite market downturns. If you ask a market or slightly below market rent, you will always be at 100% occupancy.

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