Posted over 7 years ago

Top 5 Reasons to Invest in Real Estate Instead of Paper Assets

(1) CONTROL - Many money managers will advise you to diversify your investments in paper assets such as mutual funds and cd's. Yet as investors search for investments with lower risk, they increase the level of risk for themselves by investing mainly in mutual funds. The problem being you have no real control over the assets value since you cannot renovate or improve its value like you would real estate. You cannot control the risk of the asset like you could with real estate by using creative legal structuring, having proper insurance, or protecting yourself against economic cycles through positive cash flow. Due to the lack of control of the asset, mutual funds are some of the worst investments available. On the other hand, real estate can be controlled much easier by investing correctly in assets that are under market value with multiple exit strategies that help increase the return on the investment while decreasing the risk. An increase return on an investment does NOT have to mean an increase in risk.

 

(2) INFLATION - Paper assets do not have inflation protection. With all of the "funny money" the U.S. government has printed in the past couple of years our economy is in shambles. Just look at the price we pay for commodities and gasoline, inflation is already happening. People’s paper assets primarily stay the same while everything else goes up in value, so most investors are losing money and being left behind by not investing in assets that keep up with inflation. Real estate value generaly goes up even though the demand for it stays the same thus keeping up with inflation, regardless of how much the dollar weakens. By investing in real estate you diversify into another asset class instead of the U.S. dollar which since 1971 is considered one of the worst investments of our time.

(3) DEPRECIATION - Paper asset income does not come with tax benefits like real estate even though taxes are one of our biggest expenses in life. Learning ways to reduce taxes is extremely important, especially in our current economic time. Reducing the taxes you pay to financial predators such as the U.S. government will help you get ahead financially. It's their job to find additional ways to tax you and it’s your job to find ways to reduce or even eliminate those taxes. When investing in real estate you get depreciation benefits which topically equal 60%-80% of your purchasing price divided by 27.5 years. For example, if you purchase a property for $100,000, then $80,000 (depending on the land value) is written off over 27.5 years, which means you get a $2,909 tax deduction on any income that property produces. So if you make $8,000 per year in rental income you are only paying taxes on approximately $5,000 instead of the original $8,000, which is huge when compared to other investments.

(4) LEVERAGE - Rarely can you use leverage with paper assets to borrow money against them and increase your return on investment. When using leverage, assuming it done correctly, you can increase your returns. With paper assets using leverage is extremely risky since there is no control. That's why financial planner and advisors will tell you leverage is risky. However, it's only risky on assets you have no control over or when you over leverage without looking at the cash flow closely after debt service. If you purchase the same $100,000 property (in point 3 above) but get an $80,000 loan at 5.5% for 30 years and put 20% down you now have a monthly payment of $454 per month leaving you with $213 per month in positive passive cash flow ($8,000 / 12 months = $667 - $454 payment = $213).  That means on your $20,000 you are making $2,556 per year or a 12.7% return on investment instead of an 8% return on investment on your $100,000.  Using leverage correctly is a great way to increase returns which is extremely necessary in an inflationary economy.

(5) CASH FLOW - Most paper assets do not produce positive monthly cash flow.  Cash flow is everything.  When you invest in most paper assets you typically invest for capital gains, not cash flow.  Capital gain investment income has higher taxes and do not provide you income when the economy is doing poorly.  You can easily lose your investment or a large percentage of it, like we saw when most American's retirement and 401k accounts lost 40%.  If you invest in cash flow, the value of the property does not matter.  You are seeing your return on investment on the cash flow and no matter what is happening in the economy you are not in danger of losing the asset or your initial investment.  You will typically see your cash flow come rain or shine even with fluctuations in the general overall economy. However, you are much less susceptible to economic fluctuations if you are prepared. By building your cash flow stream over multiple asset classes you will be in a much better financial position where your monthly expenses will be covered by the cash flow. As your expenses rise with inflation so does your cash flow due to rental inflation as well.


Comments (34)

  1. Is 80% leverage a pretty high number for real estate investing? I realize that this could be the only way you can afford an investment and there are also tax benefits to using debt but also I would imagine the risk would increase proportionally. Just curious what a normal level of leverage would be.


    1. Leverage


    2. I believe leverage that high lessens risk to the investor, should they decide to just default/walk away on an underwater property.  And lenders are perfectly willing to lend at 80%.  Yes, it's common.    

      A home we bought with 80% leverage for under market value, has grown in value even more, to the point where we are now doing a cash out refinance.  We will get our original down payment back so we could buy something else, and the home will be financed at 75% LTV.  

      We have noticed that rent rates seldom go down, so we feel confident the rent will always pay for the mortgage.  If not, we have cash in reserve.  If that runs out, there is a large line of credit  we could draw or personal income to use until we sell it.  We like single family homes that are newer and affordable to first time buyers.  They seem to be the most liquid.  Those are our exit strategies.

      If you could buy one home outright for $200K, or five $200K homes for $40K down and a mortgage, which would be less risky to you?  Which method would produce the better return on investment?  Also, are you willing to reinvest any cash flow? Or are you at retirement and need to live on that cash flow?  

      By the way, if home prices tanked, we want to have enough cash in our pockets to put down 20% and buy more for a bargain.  I like having cash free ready for an opportunity.  I feel like the best return on our investment is when we first buy an undervalue property.  Getting free equity boosts returns like nothing else!


  2. Thank you for posting this. It is very insightful.


  3. Thanks for a great article! I am now realizing how much more I could have gained financially, if I had started investing earlier in RE instead of my 401K!   I've recently decided to refinance an investment property and will now have a whapping $530 cash flow.  Two years ago, I almost sold it at a loss because I was so frustrated as a landlord. I no longer have that headache since I'm using a property management company.  But there are so much to learn about real estate and I am so thankful to have found this site!


  4. I have to do more research on leveraging. But I do understand dividing assets amongst different classes as a way to minimize lost. And keeping a consistent cash flow.


  5. Thank you for the post @Mathew Owens. I considered becoming a stock investor however the more reaserch I do, real estate brings a lot more appeal. I look forward to following your example and attaining  cashflow by utilizing leverage. In my opinion the most important part for any investor is: control. Thank you Mathew.


  6. When you buy stock for cash flow, you are buying for the dividend. Most dividend paying stocks have a yield around 2 to 4 percent (for example, 2 stocks I own, Johnson&Johnson pays 2.7%, Boeing pays 3.4%). You can buy stocks on margin, but the interest rate at my broker is 8.25%. So using leverage on stocks does does not increase cash flow. It only makes sense if the stock appreciates quickly. Real estate is one of the few areas where leverage makes sense for a long term investment.


  7. Another article mentioning leverage again...I'm starting to like this concept.  I can't wait to get fully immersed into this. You're awesome @Mathew Owens


  8. This is awesome. Thank you!


  9. Still don't know where you got that $8,000 number from...


    1. If not mistaken, the $8,000 figure is the assumed gross annual rental income that was indicated in the last sentence of the third reason to invest in real estate - Depreciation. Correct me if I'm wrong, I can take it.  


      1. John, actually the $8k of income was just assuming you are buying at an 8% cap rate.  Meaning you are buying it for $100k and it should produce $8k (8% cap rate) per year in NET revenue before depreciation or any loans.  I had not clarified where I got that number from in the article.  Hope it makes sense now.


  10. I love how Bigger Pockets breaks it down. and I also love the numbers game.


  11. This is some good food for thought, especially points 3-5. However, some of what you say is troubling enough to undermine your credibility.

    "[M]utual funds are some of the worst investments available" - I can think of many worse, and few better.

    "Capital gain investment income has higher taxes [than "cash flow"]" - This is completely wrong.  


    1. @ Eric Glynn, thanks for the comments I appreciate it.  However, short term capital gains which is common in flipping properties or trading stocks does have a higher tax rate than rental income.  Also, mutual funds lack control nor any real investment plan and that is why I am saying its one of the worst investments.  When investing in mutual funds you are hoping they increase in value which is not a true investment strategy.  A proper strategy encompass true predicable returns if managed correctly.  That is my opinion at least.  Not sure if my credibility is still under question.  ha ha

      @ Joe Calderon Thanks for commenting.  I was using an arbitrary number of $8000 for net rental income after all expenses (taxes, insurance, management fees, repairs, etc) just to simplify the summary of the return on investment difference.  Sorry I did not clarify in more detail.  I was using $8k which is 8% of the property in the examples purchase price of $100k.  Basically buying at an 8% cap rate in the example.  

      @Tim Chasteen Sorry for not laying out the other costs involved.  But I was stating that $8000 was the NET after all of those expenses basically buying at an 8% cap rate.  So it would still be positive cash flow after the mortgage payment.  Hope this makes sense now.


  12. NO.3, 4 and 5 are highly recommended! Thanks!!!!


  13. This is great to know.


  14. Great points!

    On (1) though:

    ETFs are an alternative to Mutual Funds, and generally offer diversification without the huge added costs of portfolio management. Also, capital markets do offer one advantage, in terms of lower risk: liquidity. Securities can be quickly and easily traded, so, in the event of adverse market conditions, you can "get out" quick.


  15. I agree with Rob Stuart. On the other hand as a new (to RE) investor, Leverage is very interesting.


  16. Your anti-government sentiments are really uncalled for in a post of this nature.


  17. @ Tim Chasteen Thanks for spelling out the reality of cash flow. Hidden costs were completely glossed over by the author.


  18. Some good points, but I don't understand how "($8,000 / 12 months = $667 - $454 payment = $213)" is positive cash flow. Here the investor is only deducting rental income with mortgage payment, what about taxes, insurance, property management, maintenance, etc? More than likely the investor would have a negative cash flow?


    1. M = P[i(1+i)^n]/[(1+n)^(n-1)]

      M= monthly mortgage

      P= principal or borrowed amount

      i= monthly interest rate

      n= number of payments in months


  19. Great read!


  20. Thanks Mathew, great stuff here... The example you gave in #4 (leverage) is twisting me up a bit. For some reason the math isn't working out for me (I'm a newbie). 80,000 @ 5.5% for 30 years = 84,400 / 30 = 2,813 per year or 234 per month payment (I think that's right). 8,000 per year or 667 per month in income. So, 667 - 234 = 433 positive cash flow. I guess the 454 number threw me off. Can you help clarify? Thanks!


  21. Great! This can help me explain my investment choices to friends and family. I keep getting the wierd eye when I tell them I'm going to invest in real estate (mostly because of the collapse a few year ago). This is a great explanation :)


  22. Graeat tips!


  23. great breakdown


  24. Thank you very much


  25. Excellent breakdown.


  26. Wow ! Interesting . I have a lot to learn! Thanks !


    1. Great article, I have so much to learn!


  27. great post 4 and 5 are my favorite reason.