Have you ever wondered why so many real estate investors seem to “get rich”? We’ve all heard about those wealthy real estate tycoons! The fact is, most people know that real estate builds wealth, but very few understand how it does so!
Unlike your W2 job that only provides income in ONE way (you give your time, they give you money!), real estate makes money in multiple ways! This is one of the reasons that real estate owners “get rich” while most W2 income-earners only “get by”!
Let’s look at a hypothetical example to illustrate how it is that real estate makes money in five different ways.
For simplicity, we’ll assume you buy a single-family home rental property.
- Property purchase price $100,000
- $30,000 down payment
- $70,000 loan (30-year amortization, 6% interest rate)
- Monthly mortgage payment ~ $420 ($70 principal and $350 interest).
- Monthly rent is $1,000
- Monthly expenses (property tax, insurance, repairs, property management, vacancy) ~ $500.
- Resultant annual cash flow: $1000 – $350 interest payment – $500 expenses = $150.00
Now lets take those assumptions and look at how the property is making money for you.
The rental income ($1,000) minus the mortgage interest ($350) minus all of the monthly expenses ($500) leaves you with $150/month of residual income (or $1800/year). That $1,800 divided by your $30,000 down payment is the portion we call the Cash-On-Cash Return. That’s a 6% annual return.
Principal Pay Down
Unlike your personal home, where you pay the mortgage, your tenant pays it in your rental property. The monthly principal portion of your $70,000 loan on this property is initially around $70/mo. That’s $840/yr that the tenant pays down for you. $840 divided by your down payment of $30,000 is another 2.8% of annual return.
Although this is not guaranteed, historically, real estate appreciates at a rate of 3-5% (https://www.homesforheroes.com/blog/normal-home-appreciation-rates/). If we assume a 4% rate, that means your property will appreciate from $100,000 to $104,000 in year one, which would seem like a 4% gain. But it’s actually better than that. Your $4,000 gain is based on your $30,000 down payment, another victory for using financial leverage. That means you invested $30,000 and received a $4,000 gain – that’s a 13% return!
As a rental property owner (whether a single-family home OR a commercial real estate property like an apartment complex), you’ll receive tax benefits from the IRS for owning real estate! This can include both the mortgage interest deduction that you likely already use against your income AND depreciation. With the right strategy and planning, you’ll often pay little to no tax on your investment income. The numbers can vary depending on your specific situation, but conservatively, we can estimate another 5% of effective return from the tax savings.
Many people forget about this one! As you likely know, inflation erodes the value of your savings because the purchasing power of each individual dollar goes down over time. However, inflation ALSO erodes the significance of your mortgage debt balance. Your $70,000 loan in today’s dollars will be paid back with less valuable future dollars. The amount ($70,000) will be the same, but each year, due to inflation, $70,000 is worth less. This means you’ll effectively be paying back less value than you borrowed. Again, the exact amount of “return” is hard to quantify, but if we assume a 3% annual inflation rate, your debt is being debased, and you’re saving another 3% annually on your mortgage payback.
If you add all of those up, your annual return is around 30%! When interest rates are lower, you’ll make even more, as your mortgage expense will go down.
Of course, this is an oversimplified example, but it should illustrate the point of all the ways real estate puts money in your pocket. And although this example illustrates numbers for a single-family home rental, commercial real estate (e.g., multifamily apartments) works similarly – but on a much larger scale!
Despite the multiple benefits of investing in real estate, most people never get started because they are fearful of the unknown and of doing something different than following the traditional 401k path to retirement. However, education can remove your fears and also reduce your risks as an investor! If you’re just starting your real-estate investment journey (or just thinking about starting), keep learning and start taking action, as everyone with a W2 paycheck can build more wealth than they ever thought possible!
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