It has been said that the upper-income Americans retirement portfolio has an average of 1.2 investment properties. If there is one very true fact, it is this. Real estate has always been a very valuable part of any well-diversified portfolio. As we all strive to save for the day when we no longer want to work—and have the assets that allow us to do so—we need to look to a variety of investments such as stocks, bonds, mutual funds and real estate.
Owning property other than one’s own home is not for everyone. An investment property is a living and breathing asset that serves as a monthly reminder of your goals for your future. The largest disadvantage of property investment is liquidity. Your investment isn’t going to lose 20% of its value in a week like the stock market has done before, but you can’t access your cash quickly, either.
Real estate also entails expenses and your personal time investment, unlike a stock or bond. However, it can be a vastly superior growth investment for your portfolio. Yes, you have to deal with tenants, vacancies, roofs, fences, heating and air conditioning units, paint, flooring, and other maintenance tasks, but there are so many pluses, too. Your investment property can provide a manageable, steady monthly cash flow, provide a hedge against inflation, and provide diversification from equities like stocks, bonds and precious metals. It has tax advantages too.
The largest factor of all is leverage. Other people’s money (in this case, the bank’s) is the key to rapid growth. For all these reasons, real estate makes an incredible wealth-building tool for savvy investors.
There are five different “returns on your investment” when owning a rental property. Let’s take a closer look at each of the five and what they provide for you, the investor.
- The Capitalization Rate (or “Cap Rate”)
This is simply your gross rental income minus all your expenses, including taxes, insurance, repairs, utilities, and mortgage payments. Most cap rates float between 4% to 7% these days. Your expenses, noted above, offset some of the rental income for tax savings of a portion of your rental income.
- Depreciation
Depreciation is a tax write-off that accounts for the way buildings lose value as they get older. Most investors use a straight line 27.5-year schedule of deductions. Let’s take a look at an example. If you own a $500,000 duplex, you take approximately 75% value for the building ($375,000) and divide it by 27.5 years (your depreciation schedule). As a result, each year, you’ll take $13,636 in tax deductions for depreciation. If you’re at a 35% tax bracket, that’s $4,772 you’ll save in taxes each year.
- Mortgage Leverage
Let’s say you put 30% down ($150,000) on that $500,000 duplex. That means the bank loaned you the remaining $350,000. Each month, your tenant(s) are buying down principal; each time they pay you rent, that covers your mortgage. At a 6.25% interest rate, your tenant will have paid down your mortgage principal by $4,101 in year one. Then, each subsequent year, the amount of your principal paydown continues to grow.
- Appreciation
Property in the Sacramento region has risen an average of about 4% since 1985. The great thing about this is that you are earning this return on the entire $500,000 value, not just the $150,000 you put down. That is $20,000 per year towards your nest egg. This income is not realized until you sell the asset, but it is the other big plus of owning rental real estate.
- Rental Increases
Our region has had the highest rent increases in the nation since 2011. We are the benefactors of the wealthy Bay Area. This has been a boon to our rental rates, but an expense for the renters of our region. These increases do hedge against inflation, and when you make that last mortgage payment, you will really start to realize the tidy sum each month.
If you add up the net income, the tax savings after depreciation, the principal paydown of your mortgage by your tenant, and the appreciation, your annual rate of return is closer to 25%. Most people do not look at it this way, but it is a fact.
There is a saying in our business: “Don’t wait to buy real estate; buy real estate and wait.” Overall, owning rental properties is more of a long-term hold, but it can really boost your retirement situation, and it can be an asset to your family should you pass it on to them in your estate. If you’re interested in exploring this opportunity for your own future, please contact me to discuss your options.