Why Buy & Hold Is Such a Powerful Investing Strategy
As I’ve noted before, the current market is not a particularly good one for newbies or for big moves by seasoned investors. But that doesn't mean one should abandon the idea of buy-and-hold real estate investment.
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Indeed, I am convinced that buy-and-hold real estate investment is the best investment around. It is, as my dad likes to say, the best way for someone of modest means to become independently wealthy.
The IDEAL Investment
The way we like to think of it is that buy-and-hold real estate is the “IDEAL” investment, which is an acronym for why it’s so good.
The income from real estate is just the cash flow that an investment property brings in. This should be seen as the cherry on top, though. Many new investors think that they can buy enough properties to just live off the cash flow on a beach somewhere. Yes, this is possible. But if you use debt, it will take quite a while and quite a few properties.
But that doesn’t mean the extra income isn’t nice. Many stocks don’t give out dividends and no bonds do. So the cash flow is definitely a nice bonus. But that’s what it is — a bonus.
The government considers a property to depreciate in value from the purchase price to zero in 27.5 years. (39 years for commercial real estate, and this only includes the property, not the land. The property is usually 80% of the price and the land 20%.)
Thus if you buy a property for $275,000 (assume no land value here), every year it “loses” $10,000 of value according to the government. This means if you make $10,000 in income with your property, you made nothing according to the IRS and owe no income taxes.
This also goes for other income if you are an “active investor,” namely if investing in real estate is your career rather than a form of passive income. The rule is you need to spend 500 hours a year to be considered an active investor. (Talk to your accountant about this if you are not sure you qualify.)
When you sell, you have to pay taxes on whatever depreciation "losses" you recapture, but there are two ways out of this. You can do a 1031 exchange and continue to defer that gain into another property, or you can pass it onto your heirs and the basis will start over.
There’s also the mortgage interest deduction. So yes, there are a lot of tax advantages to holding real estate.
What got my father first interested in real estate was looking at an amortization table. One of the big things successful buy-and-hold investors do is get long-term bank debt on their properties and get rid of private loans, and especially hard money loans, as soon as possible.
Yes, in the beginning, particularly with a 30-year loan, you are not paying off much principal. But each month you pay off more and more principal and less and less interest. So there is a bit of exponential growth here.
And it’s nice to have some forced savings through principal paydown rather than paying all of it away as you would with an interest-only loan or rent.
In the long run, real estate goes up in value. Yes, there are exceptions like the 2008 financial crisis. But usually, it goes up, and over the long-term, it basically always goes up.
Appreciation also acts in a bit of an exponential way. For example, a property bought for $100,000 goes up 5% in year one, so it goes up by $5,000 and is now worth $105,000. Next year, it goes up 5% again. Well, that’s a gain of $5,250, so it’s worth $110,250. The next year, it would be an increase of $5,512.50 and so on.
One of the big advantages of real estate is leverage: the ability to use OPM (Other People's Money).
For example, if you buy a property for $100,000, but get an 80% loan, you only put down $20,000. Now if the property goes up in value by 5%, your return is actually 25% ($5,000 / $20,000). Which is a huge return, especially with the rest of the advantages listed above!
Now yes, leverage is a two-edged sword. Real estate can go down, which would lead to a 25% loss. But two points work against this. One, real estate goes up in value over the long run as listed under “A,” which is why buy-and-hold real estate investment is a “get rich slow scheme.” And two…
Built-in Equity & an Inefficient Market
Unlike the stock market, real estate is a very inefficient market. The biggest so-called “disadvantage of real estate,” namely that property is relatively illiquid, provides a great opportunity.
Because real estate can’t just be sold in a day by pressing “sell” on E-Trade, it means that you can find those motivated sellers and value-add deals and buy under market. With stock market investing, it’s possible but very, very difficult. After all, Warren Buffett beat a hedge fund manager in a bet by simply buying an index fund!
If you get a good deal, that insulates you from the risk of leverage.
For example, if you buy that hypothetical deal above for $100,000, but the property is worth $120,000, you have a $20,000 cushion right off the bat. If the property goes up in value by $5,000, you made 25% (assuming you got an 80% loan). But if it goes down in value by $5,000, you still have $15,000 of built-in equity and haven't lost anything.
For these reasons, I strongly believe buy-and-hold real estate is the best investment around. At the time of this writing, it may not be the best thing to jump into headfirst. But the market will normalize soon enough. Therefore, buy-and-hold real estate is definitely something you should consider investing in (or investing more in) going forward.
Are you investing in buy and hold?
Tell us why or why not in the comments.