Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.
You know, you’ll often hear people say that they don’t like real estate because if you look at the long-term returns of the stock market seem to be a better return overall. Well of course when they say stuff like this, they are leaving out a few important things, a few key things because they’re looking at real estate as being a very one-sided or one dimensional asset, and that’s not the case as it is with most other investments like the stock market. First, when people say the stock market, what they really mean is something like the S&P500 or the Dow Jones Industrial Average.
These are not the stock market, rather they are indices filled with some of the leading companies in the us. You’ll often hear that the stock market makes returns somewhere from seven to 8% or 9%, 10% annually. And this is really based on the index returns rather than the market itself. Second, while a seven to 10% return is good annually for the average person, it is not a good return or even a great return for the professional investor. And when you stack up the returns from real estate against the stock market, they often only factor in that one profit center in real estate, and that is appreciation or capital appreciation, or you might just call it capital gains.
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Throwback Thursday Episode (The episode originally took place in the year 2023)
This episode is part of our Throwback Series and may include references to older content such as webclasses, events, promotions, or links that are no longer active or available. While the conversation and insights still hold value, please note that some information may be outdated.
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The reality is, is that there are four ways you can make money with real estate that when you add them all up together make for a considerably higher return than the stock market.
And these profit centers are the reason that real estate is one of my favorite investment vehicles. And I’m gonna throw a bonus profit center in there today. We will call it the fifth profit center, which I’ll talk about here in a minute. But at the end of the day, you have to understand that real estate is multifaceted or multi-dimensional. It is not just one rate of return. You have to look at it holistically and look at each of those returns together to really understand the true power of real estate and what it can deliver for you as an investment. Now here’s a quick word of clarification as I talk about this, realize that I’m talking about investment real estate, not property that you buy specifically to run a business or more specifically your personal residence. And as I’ve talked about in previous episodes, your home is not an asset.
It may be to the bank if you have a mortgage on it, but it’s technically not a asset. It doesn’t generate cashflow or income, it puts money in the pockets of your county for property taxes and money in the pockets of your mortgage lender. If you have a mortgage loan on it, it’s not putting money in your pocket, at least not unless you sell it years down the road and realize the gain in terms of capital gains. But essentially it’s an expense. You’re putting money into it every year. So from that perspective, investment real estate is investment property that puts money in your pocket.
Now the first profit center is essentially the cash flow or the cash flow on operations of your business. If you’re holding real estate as an investment, you will have tenants. And each month these tenants pay rent. Now, let’s say you own a home and you are receiving a thousand dollars a month in rent.
Great, that’s $12,000 a year in gross income. When you subtract your expenses, which includes things like property taxes, insurance, your property management, if you have a property manager and you’re budgeting for vacancies and your budgeting for a turnover, because ultimately your tenants will move out, then what you’re left over with is your net operating income. This is what’s left over to pay your mortgage payment, also known as debt service. And then anything left over after that is your cash flow, often referred to as positive cash flow, but it’s cashflow nonetheless. And so this is the cool thing about real estate is that immediately month one, you can be receiving income or cashflow from your property, which is a form of income. It is a form of profit. And over the course of the year, you will have cashflow over the course of that year. And over the course of years you’ll have cash flow over the course of time that adds up.
But this is just one pillar or one asset profit center. And you have to understand that a lot of people buy real estate specifically for the cash flow of that real estate. But this is great if you are in a position where you have time on your side and you can let the equity grow in the property and you’re just in it for the cashflow. But some investors are focused on growth and they want the appreciation. And so cashflow becomes less important to them. They don’t need as much of it as they would if they were focused on cash flow. So you know, there’s two types of investors, those that are in a position where they don’t need the cash flow, they’re focused on capital growth and growing their portfolio. And there’s those investors that have their goals set on maximizing their cash flow and they’re not so concerned about the capital growth of their property or properties.
And they’re gonna focus on maximizing their initial cash flow. Now I’m gonna compare these for you in a minute here and you can see which ones provide you the greatest returns over time and in often some cases give you the greatest returns immediately. But that’s not the end of the story here. Remember, there’s four major profit centers. So the next one I want to talk about is the amortization of the loan. I’m going to make the assumption that you have mortgage financing on your property and that that is the way you want to invest as most investors do. And something that certainly I’m a big fan of and we are a fan of here at Norada Real Estate, is because you can leverage your investment capital and make it go further and build a larger portfolio by using OPM other people’s money. So amortization is simply the concept of paying down your debt each month When you make a mortgage payment or a debt payment, however you want to call it.
Now remember it’s your tenant that’s making that debt payment, not you. But every month when you make that mortgage payment out of your net operating income, a portion of that goes towards paying down the principle on the loan that you have on that property. So when you’re talking about a 30 year fixed rate, fully amortized loan, which is the most common type of financing that you get on rental property, you’ll be making a mortgage payment that pays down that principle over 360 payments. Of course, if you pay it off sooner or you accelerate those payments, you’ll have fewer than 360 payments, but you’ll ultimately pay off that loan over time until it reaches zero. And at that point, whatever you had as a principle amount in that loan becomes equity. So your equity grows as the loan shrinks, and that’s all that amortization is. It’s the pay down of the principle on that mortgage loan, which increases your equity at the same time.
So if you look at that or you step back and think about it, it’s really a form of return because the equity is growing in the property as your tenant pays down that mortgage. Put another way, think of it this way. Your tenant is paying rent and that rent covers the debt payments and that principle pay down included in that debt payment is actually profit to you. And we’re gonna take a look at a real example here in a moment where I break down a property and show you what the rates of return are on each of these profit centers. Now there’s another similar form of profit that comes from the appreciation. Sometimes people think of appreciation as frosting on the cake. Other investors, those that are growth oriented like I was talking about a minute before, where cashflow’s not so important and they’re focused on maximizing their appreciation, that’s not the frosting on the cake, it’s the cashflow that’s frosting on the cake.
Some investors are looking for true rapid wealth creation in the form of net worth. These are unrealized gains in the property. As the values go up, the equity goes up. Now some investors don’t invest for that appreciation, they’re just focused on cashflow. And there’s not one right or wrong answer here. It’s really what you are focused on as a real estate investor, I like both. I want both. Sometimes I am investing knowing that I’m buying property specifically for the capital appreciation because of the growth in the area. I just know that it’s not gonna perform well in cashflow terms in the short term, but it will do very well in terms of that equity growth over the medium term because of the growth in the area. And so you gotta think about what type of investor you are and what you’re looking for. If you have a lot of time on your hands, you’re a younger investor or you have a lot of capital to deploy and you want to grow a portfolio and grow a portfolio that is focused on appreciation, equity, growth, again, you don’t wanna speculate, but you can focus on investing in properties and markets that show strong growth and growth potential.
Now those are essentially the three main pillars we’re gonna talk about a fourth one here called depreciation. Now this is really not necessarily directly a form of profit, but indirectly on the backend it is depreciation is often referred to as a phantom return. The basic concept of depreciation is that your investment property is made up of two parts, the land and the improvements that sit on the land, which is the property itself, like the house or the duplex or whatever it may be. Now, appraisers will assign a percentage value to the property based on these two parts. For example, they may say that the total value of this property is 20% towards the land and 80% towards the improvements. Now, over time, that property, more specifically the improvements that sit on that property, the sticks, bricks, copper, and concrete will deteriorate. So the government has in the IRS, they will allow you to write down that 80% or that 80% value over a certain number of years depending on the type of real estate it is.
If it’s commercial real estate, it’s 39 years. It’s it’s residential real estate like a single family home or a fourplex or a duplex. It’s 27 and a half years, which means that over the course of 27 and a half years, you can take that fraction of that property, 27.5 divided into that 80% value of the property when you first acquire it, which is your cost basis. And use that to write down the income on that property, meaning that it’s essentially profit to you. So let’s just say that you are purchasing a 200,000 property and 160,000 of that is the improvement, which is the house itself that can be depreciated over 27 and a half years. And if you do the math, 160,000 divided by 27.5 is $5,818 per year. That is the amount of quote unquote loss that you can take against that property because it’s depreciated, or at least in the eyes of the I R s, it’s being depreciated each and every year.
So even though no money is coming out of your pocket, you can take that $5,818 each year as a loss towards your income. And this is why it’s called phantom income. You don’t have to do anything to get it. You don’t have to spend a single penny to get it. So if you assume that you’re in the 30% tax bracket, that means you apply that 30% to your depreciation of $5,818 and that nets you $1,745 in annual tax savings. So even though it’s tax savings every year, you can think of it as profit because it’s taxes you never had to pay because of that depreciation. So it is a wonderful thing, a powerful thing. There are very few asset classes that provide you this form of profit in the form of depreciation and real estate is the number one asset class that allows you to take a profit from the depreciation of those improvements on the property.
And if you never sell that property, if you keep it indefinitely, you will never have to repay any of that in the form of what’s referred to as recapture taxes or recapture. Now, there are ways to of course, defer that indefinitely, which means that you would never have to pay it even if you did have to sell the property through 10 31 exchange or otherwise. But for the sake of this podcast episode, let’s just say that you can with proper tax strategy, keep that depreciation and that profit quote unquote forever. So that’s depreciation. Now, if I were to talk about a fifth profit center that makes real estate the most powerful investment, it would be this, it would be leverage. Now, leverage is simply this. It’s the ability to use other people’s money to make your investment capital go further. It’s simply a technique that real estate investors use to increase the potential returns of their investment capital and to build wealth faster over time.
And it’s a very, very powerful thing because if you think about the fact that lenders are willing to lend you up to 80% of the purchase price of a property and sometimes more, but 80% of that purchase price, you are essentially leveraging your investment capital five to one, which means you can go five times further for the same investment dollar, using other people’s money in the form of leverage called mortgage financing. So that’s basically what leverage allows you to do. Now, it has pros and cons of course, you know, leverage is essentially the power to use other people’s money to purchase real estate. And that’s a great thing. But you have to understand that there are potential risks because when you increase the amount of debt service that you have to pay each and every month, you’re minimizing or reducing your margin for error. So you’ve got to obviously make sure that over the course of time, over the course of a year or more, you have enough rental income coming in to cover your expenses, cover your debt service, and leave some extra for you to cover a turnover, a repair maintenance, a capital expenditure, like something that’s gonna happen every 10 or 20 years, like a replacement of the roof or replacement of the HVAC system or a furnace or a hot water tank or whatever it may be.
So these are things that you need to consider. Generally speaking, investors use what will refer to as a conservative down payment, and that’s usually 20%. And that’s a good way to balance risk and reward because you will get your best or maximum amount of financing for that property without incurring extra servicing fees such as PMI, private mortgage insurance because when you go over 80% often you’re gonna have to pay a premium in the form of mortgage insurance for having a higher than 80% loan to value. Investors will often put 20% down or 25% down. Those are really the two sweet spot numbers. Sometimes investors put 30% down in order to get a better rate and term on their mortgage financing or to lower their debt service each and every month because of the lower amount of financing and therefore they increase the cash flow on their property, increasing that buffer on that property.
Should there be a longer term vacancy or an extra repair or maintenance expense that comes up? That is a good way to basically protect yourself in the form of extra cash flow, especially if you’re investing in a more expensive property in an area that is just more expensive with lower cash flows, but have stronger appreciation potential. And this is what we see in many areas right now, especially when it comes to new construction financing. Often investors will put larger down payments like 25 or even 30% to lower their debt service, increase their cash flow, and have more cushion or more margin for error should something happen over the course of next year, two years, three years. It’s just a smart thing to do. It also gives you a slightly better term in terms of the mortgage rate on that loan if you put more down.
But you know, leverage is a powerful thing. It’s a smart thing. It is a two-edged sword, but a savvy investor will always use mortgage financing to leverage their investment capital so they can acquire more property quicker and build a larger portfolio and take advantage of those cash flows. But more importantly, the gains in appreciation over time plus the depreciation across multiple properties rather than one or fewer properties. Now let’s take a quick example. This is a little bit in terms of math, but if you look at a property, and we’re making a hypothetical example here, but if you have a purchase price of $200,000 on a property and you want to put the minimum down payment of 20%, that’s a $40,000 down payment. Now, let’s just assume the cashflow is conservative and I’m gonna call it $200 a month, which is $2,400 a year. Doesn’t sound like much, but I’m using a conservative number here.
I could use 300 or $400 a month and that would be a realistic example as well. But I’m just taking a very conservative example and let’s just assume it’s a 30 year mortgage. So 360 months of mortgage payments. And even though mortgage payments right now are under this 8% plus or minus interest rate, I mean it was wonderful when we saw 6%, 5%, even four and 3% rates, which seems not all that long ago. Let’s just go with the high 8%, high 8% mortgage rate today. We’re also gonna make the assumption that appreciation is averaging about 5%. It’s been higher than that, but let’s just use appreciation of 5%. So we have a $200,000 property, $40,000 down, a very conservative cash flow of 200 a month on a 30 year fixed rate mortgage at 8% and a 5% average appreciation rate over time. So what do we get if we just look at year one, I can go all the way down to year 30 here, but in year one, that’s $2,400 of cashflow.
If you take that number and you divide it into your down payment, that was $40,000, you have a cash return cash on cash of 6%, not great, not bad, not abnormal, but 6%. Again, that could be higher, but we’re taking a slightly conservative number. Now we’re gonna look at the two equity factors here. One is the amortization. It’s slow in the beginning and it accelerates over time because if you understand how mortgage loans work, you’re paying down the least amount of principal in that first year. And then it increases year after year after year as the mortgage gets amortized. So in the first year, that’s the smallest amount, call it the worst case, but you’re gonna amortize a little over $1,300 of principle in that first year, which is only a 3.3% return on that amortization. So it’s another 3.3% on top of that, 6% in cash flow.
But where it starts to get pretty exciting is the appreciation that happens over time. Let’s just say it appreciates 5% in that first year. Again, it’s a $200,000 property. So at the end of the first year, it’s appreciated only $10,000. It’s still $10,000, but that $10,000 divided into your $40,000 down payment is a 25% return. So that $10,000 or that 25% added to the previous two rates of return gives you an amazing 34.3% total return on investment. And keep in mind, I am not including tax benefits here. The depreciation I was talking about earlier, that is not factored into this calculation. I’m just looking at your total return on investment from the realized and unrealized gains in this first year on that $200,000 property. So for those of you looking at property values of potential real estate investments around the country, especially many of the ones that we offer through our pipeline and our network that range all over the place, but let’s just say from 150 to $250,000 and you’re saying, wow, you know, property values have gone up so much in the last, you know, 3, 4, 5 plus years compared to what I was looking at five years ago or more.
Well, yeah, property values have gone up. They have appreciated through various factors. Supply and demand is a big one, but the inflation has been another one. But rents have gone up considerably as well, especially over the last three, four years. So you’ve gotta put all that into perspective. But we’re now talking about 150 and $200,000 properties versus what we were talking about. Let’s just say five years ago being a hundred, $120,000, maybe $150,000 properties on the higher end. But let’s just call this $200,000 property the norm. What happens like five years down the road, now you’re making a cashflow of $2,808 a year. That’s a 7% return. When you divide that into your $40,000 down payment, what’s happening on the amortization? Well now you’re paying almost $7,900 off in amortizing that loan, which is now about 4.6% as a return on that $40,000 down payment.
What is happening with that 5% appreciation average per year on that property? Well now you’ve got a $255,000 property. So that has given you a 30% appreciation return on that $40,000. And if you add those up in year five, again without depreciation, you’re looking at a 42% total return on investment in year number five. Now, I’m not adjusting for inflation on these, so keep that in mind. But remember, real estate is a natural and powerful hedge against inflation because the land values goes up because of inflation as well as supply and demand dynamics. And demand is very strong right now. And the improvements that sit on that land, the sticks, bricks, copper, and concrete, those are all natural hedges against inflation. They will go up each and every year because the supplies, the inputs that go into constructing property, as well as the labor that goes into constructing construction and properties of all kinds goes up in each and every year.
So it is a natural hedge against inflation. So you can see where I’m going with this. You know, in, in year five you’ve got roughly a 42% total return on investment and on and on it goes. Plus you have the ability to take advantage of that depreciation. Plus in time. You also have the ability to refinance at a lower rate when rates come down. Remember, I’m using 8% as a mortgage rate in in this example, but when rates come down, you can refinance. And not only that, you can also refinance your properties down the road and pull money out, pull out cash from that property that you could use as down payments for additional investments, buying additional property down the road. And when you do that, when you pull out that equity by refinancing it or even using an equity line of credit, you can pull that money out tax free.
That cash that you pull out is in the form of debt. So there’s no tax on it. It’s a tax-free withdrawal from your property that you can now use to reinvest and compound those returns. Real estate is an amazing asset class. It’s beautiful for that reason. And it’s just very powerful when you know how to use it and use it, right? And if you have the right team around you and my team is here to help you, but when you have the right team around you to show you how to do this and implement it, it becomes incredibly powerful and you can build wealth very rapidly and you can be building your passive stream of income for your future, your family’s future, and their kids’ kids, on and on it goes, this is generational wealth that you could build and quite rapidly. So that is essentially how it works when you look at the different profit centers that make real estate the most powerful investment out there, I call it for profit centers.
But really when you factor in leverage, it becomes a fifth profit center and that is the power of real estate. So I hope this made sense. Definitely consider real estate as an investment for yourself if you’re already investing in real estate or even if you’re a seasoned real estate investor. Just you know, going back to the basics and understanding these five pillars of real estate and how they work and work together becomes a very exciting thing. So if you have any questions, contact my team. You know, I’ve got a team of investment counselors here that can help you in putting a plan together, getting started, or just building out your existing portfolio and just leveraging more of what you already have.
I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. We’re releasing one every week, sometimes two, and I would not like it if you missed an episode. There’s just a lot of great nuggets and good content sprinkled throughout this show. If you have a question about real estate investing or finance, simply go to passiverealestateinvesting.com and click the Ask Marco button. I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So, I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco. Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.
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