The Beauty of Buy-and-Hold | Think Realty | A Real Estate of Mind
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The Beauty of Buy-and-Hold

Most investment opportunities have one potential profit center. When you buy an index fund or a mutual fund or gold, for example, all you can really do is pray it goes up in value. If it does, you sell it, pay taxes on the gain and then take whatever is left over and adjust for inflation to ascertain your “real” gain.

Did You Know You Have Five Profit Centers in Each of Your Rental Properties When You Keep Them for The Long Term?

Most investment opportunities have one potential profit center. When you buy an index fund or a mutual fund or gold, for example, all you can really do is pray it goes up in value. If it does, you sell it, pay taxes on the gain and then take whatever is left over and adjust for inflation to ascertain your “real” gain.

If it doesn’t go up in value enough to cover your broker fees, capital gains taxes and outpace the rate of inflation, then guess what? You lost money—at least in real dollars. And since you only had one profit center, and all your eggs were in that one speculative basket, you are sunk.

Now let’s look at deeded freehold rental property (a hard asset, not to be confused with REITs or real-estate-backed securities) as an alternative asset class.

Of course, if you are flipping properties, you are pretty much in the same boat as the mutual fund investors. Actually, you are often in a worse boat because, in addition to having only one profit center, you normally need to invest a ton of your own time. So I am not talking about flipping properties; I am talking about holding properties.

FIVE PROFIT CENTERS

When you are a “real estate investor” (not to be confused with a landlord or a rehabber) and you buy and hold deeded freehold rental property for the long term (leased out to qualified tenants and managed by a professional property management company), you open up five simultaneous profit centers instead of just one. And those are:

1. Market Appreciation

Similar to the other asset classes, with rental property you also have the potential for your property to go up in value through market appreciation. But where most other asset classes stop there, you have four more potential profit centers.

2. Cash Flow

If you buy right—in an investor-advantaged market with strong rental demand, optimal price-to-rent ratios and compelling capitalization rates—then your gross rental income should cover all your expenses (taxes, insurance, property management fee, your principal and interest mortgage payment, etc.) and your monthly reserves for vacancy and maintenance, and still put money in your pocket, which is your “positive cash flow.” So, each month, regardless of what home prices are doing, you should have a stream of passive residual income flowing to you.

3. Leverage

Real estate is the most debt-favored asset class, meaning that banks are willing to lend you large amounts of money to buy it. (Try walking into a bank and asking for a loan to buy gold or a mutual fund.) Leveraging real estate provides you a number of potential advantages:

a. You can put less money down out of pocket. Many of our clients are currently buying rental properties with 20 percent down on single-family homes and getting 80 percent mortgages. Assuming you lock in a good interest rate and buy your property right, this leverage has the potential to meaningfully increase your cash-on-cash return on both your monthly cash flow and your market appreciation. Remember, even if you only put 20 percent down, you still get 100 percent of the market appreciation gain.

b. When you buy right and your tenant’s gross rent covers all your expenses, including your principal and interest mortgage payment, guess what that means? Your tenant is ostensibly paying down your mortgage principal every month, so you are building equity in your property even if there is zero market appreciation. If you buy a property for $100,000 and take out an $80,000 mortgage, and then you hold that property and rent it out for 30 years and the tenant’s rent pays down your entire mortgage principal, you will have built $80,000 in equity even if the housing market did not appreciate at all.

4. Tax Benefits

Residential investment property is also the most tax-advantaged asset class in the United States. The government incentivizes you to buy and hold (not flip) rental property by allowing you to depreciate your property over time even if it is going up in value! You first have to subtract the value of the land (which is not depreciable) and then you can depreciate the structure of your residential investment property over 27.5 years. So, if the value of your property structure is $140,000, the IRS allows you to take about $5,000 a year as a “phantom” depreciation loss and write that off against your income from the property. If you were making $400 a month in positive cash flow, that would be $4,800 per year in what would normally be taxable income, but because of your depreciation, you can take that $5,000 loss and wipe out this entire tax obligation. In many cases, you can even take your excess losses from depreciation against other forms of income—consult your CPA. Now, if you were to sell the property, you would need to recapture that depreciation loss and pay tax on the capital gain, but if you are planning to use all the proceeds of the sale to buy another like-kind property, the IRS allows you to do a 1031 Exchange and indefinitely defer both your depreciation recapture and your capital gains tax. If you continue to hold your properties (or keep doing 1031 Exchanges) until death, then when your properties are passed on to your heirs, their obligation to pay for the capital gains and depreciation recapture that you deferred is wiped out! This is all part of the government’s astonishing incentives to encourage you to hold your rental properties.

5. Hedge Against Inflation

Remember that you not only need to build your wealth but you need to defend it from inflation. If your money is in a savings account or a CD or any type of investment vehicle whereby your total interest or gain (after all fees and taxes) is less than the current rate of inflation, you are actually losing money in real dollars. Real estate, on the other hand, has a built-in hedge against inflation because home prices usually rise with inflation, as do rents. Since you are renewing your leases every year, you are able to continually raise rents over time to keep pace with inflation. Additionally, if you lock in a fixed-rate principal and interest mortgage, you are borrowing that money in today’s “real dollars” and then, as inflation rises, you are paying the bank back in reduced “nominal dollars” in the future. So, you actually have the potential to profit on the spread between the value of the real dollars you borrowed and the value of the nominal dollars you are paying back.

I want to be absolutely clear that whatever investment vehicle you choose, including real estate, no specific returns can ever be guaranteed. But the difference with real estate is that you have five potential profit centers instead of just one, so even if one or two fail in a given year, the others can help to mitigate the loss and often still result in a net gain. The potential for these multiple profit centers to accelerate your gains and mitigate your losses is the main reason why such a large percentage of affluent people choose to hold their wealth in real estate.

DISCLAIMER: This is not legal, tax or financial advice. It is for general education only. It is your duty to consult your CPA, legal and financial advisers about your individual situation and applicable law and to conduct your own due diligence before purchasing any real estate.