Someone once asked John Jacob Astor, the famous real estate investor and America’s first multi-millionaire, while he was lying on his death bed, if he would do things differently if he could start over.
Astor responded, “Yes. I would have bought every inch of Manhattan.”
While the anecdote may be apocryphal, it highlights what my father and many other investors have said: “Every time I’ve sold a property, I’ve ended up regretting it.”
There are, of course, exceptions, and obviously, this doesn’t apply to flippers. But in general, I firmly believe that buy and hold is the best way yet discovered to become independently wealthy. Indeed, a 2012 Federal Reserve Study found that the average homeowner had a net worth of $174,150, while the average renter had a net worth of but $5,100. And keep in mind that all it takes to be counted as a homeowner is the purchase of one single house. Try multiplying that a few times over and see what happens.
Buy and hold real estate investment has multiple, significant advantages over other investments. These advantages can be summed up with one nifty mnemonic — IDEAL.
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The 5 Advantages of Buy & Hold Real Estate: IDEAL
I – Income
Most investments offer either a consistent return (i.e. annuities) or the potential for equity appreciation (i.e. stocks). Real estate offers both. Good buy and hold investments offer positive cash flow from rents that not only offset the expenses and debt service, but also provide a monthly income. The average annuity only pays out 3.27% per year.
A halfway decent buy and hold investor can beat that any day.
D – Depreciation
Flipping is a great business, but one of the biggest cons is that the tax man always gets theirs. Not so with buy and hold.
The IRS allows you to write off the value of any property over 27.5 years. This depreciation counts as negative income, but it’s only negative on paper since the costs of keeping a property in good condition can be paid for out of the rental income.
Thus, the depreciation “losses” wipe out the positive cash flow from the property and remove any tax obligation. Unfortunately, due to the Tax Reform Act of 1986, only active investors can take advantage of this.
E – Equity Build Up
Real estate is the easiest investment to leverage (more on that later).
With a mortgage, unfortunately, comes the obligation to pay it back. Fortunately, the cash flow mentioned above allows an investor to pay back that mortgage without spending any of their own money. Instead, the tenant pays for it.
Furthermore, each month — assuming you don’t have an interest-only loan — part of the principle is paid off, too. Right off that bat, with a 30-year amortization, about 15 to 25 percent (depending on the interest rate) of each loan payment pays off the principle of the loan and adds to the equity you have in the property.
A – Appreciation
Real estate, like any other asset, can go up or down in value.
Many have been scared off by the crash in 2007. However, a look at the long term history of real estate prices is encouraging. The trend is consistently up. In fact, over the past 40 years, real estate has gone up an average of 4.62% per year. The combination of accelerating equity pay down (with each payment, you pay more principle and less interest), and appreciation means that the investor’s equity in any given property will grow exponentially the longer they hold it.
Some have pointed out that the stock market generally has a better return than real estate. This is true, but deceptive. That’s because real estate is generally leveraged at a rate of four or five to one. Stocks, on the other hand, are rarely leveraged much, especially after the massive losses taken by those “buying on the margin” before the Great Depression.
Which leads us to the next point:
L – Leverage
If you invest $20,000 into the stock market, and it goes up 10 percent, you’ve made $2000. If you invest that same money into real estate, you can buy a $100,000 property with an $80,000 loan. Let’s say it only goes up 5 percent. Well, you’ve made $5000. Or in other words, you’ve made a 25 percent return!
So the fact the stock market has a higher return on average is immaterial since your returns with real estate are based on a much higher amount than your principal investment.
One might think this makes real estate more risky than stocks, but that isn’t so either since, as Zack Finance points out, “Stock prices are typically more volatile than real estate prices.” Indeed, a buy and hold investor who invests right can even make it through major downturns like the recent crisis (which saw stocks drop as much as real estate, by the way) with the positive cash flow from the property. Today, housing prices have even returned to pre-recession levels in many markets.
In the long run, real estate and stocks both go up. So if you can survive the downturns with positive cash flow, you’ll be just fine in the long term.
We’re Going to Need a Longer Mnemonic
There is a theory floating around academia called the “efficient market hypothesis.”
According to Investopedia, “The theory states that is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.” The theory is highly controversial, and I think the 2007 crash basically refuted it.
Nevertheless, the theory’s problem is that it overstates its case. Namely, the stock market is mostly efficient — not completely efficient. All of the stocks are available to any given investor, and there is a wealth of information on each of these companies that is easily accessible. But as the crash showed, relying on the masses to interpret that information correctly is by no means guaranteed.
Still, the stock market is close to being an efficient market. The real estate market makes no bones about it; it is undeniably an inefficient market. There are no motivated stock sellers out there. If someone wants to sell their stock, they just sell it. Not so with real estate. Selling a house is much more difficult.
Motivated sellers or unrealized value-add opportunities create a wealth of potential bargains for real estate investors that stock market investors could only dream of. The fact that real estate isn’t as liquid as a stock is usually seen as a disadvantage to real estate, but because that makes the real estate market inefficient, it’s actually an advantage.
Related: Top 10 Reasons to Buy and Hold Real Estate
So for example, if a real estate investor buys a property for $100,000 that’s worth $120,000 with $20,000 down and an $80,000 loan, they have already made a 100 percent return. Furthermore, this significantly reduces their risk. After all, if you have a 20 percent equity cushion, the market could fall 20 percent — and you wouldn’t have lost a penny.
Buy and Hold Versus Flipping
This really shouldn’t be phrased as a competition; after all, flipping is a great business, and there is no reason that flipping and holding must be mutually exclusive. Indeed, I think flipping is one of the best ways to raise the money necessary to hold real estate.
That being said, there are several major benefits to holding that should be noted.
The first is the tax advantages listed above. The second is that holding real estate creates passive income, whereas once a flip is done, the income potential of the property has ended. Because of this, holding real estate is more easily scalable. Namely, if you flip 10 houses one year, the next year, you will start with zero. If you hold 10 houses, the next year you start with 10. And as the equity builds in these properties, it will allow you to refinance out and buy more properties, which creates the opportunity of exponential growth.
Holding real estate is the ultimate get-rich-slow scheme. By finding good deals and holding them, investors can create residual income, while also growing their equity exponentially through principle pay down, appreciation and leverage.
In other words, it’s the best investment around.
Do you agree? What’s your investing strategy of choice? Have any counterpoints to offer?
Please — don’t forget to leave a comment below!