Why Invest In Real Estate?
The following is an excerpt from the book Rockstar Real Estate Investing: Expert Advice for Making Your First Million by Jessi Johnson & Kyle Green.
Who can invest in real estate? Anyone who wants to be a millionaire or wants future financial security, that’s who! This isn’t far from the truth. Real estate investment is for anyone who’s interested in building future net worth and is tired of being a passive investor.
Passive investors are those who invest their extra income in stocks, bonds, or mutual funds and do nothing else to leverage their money. Although this might have worked in the past, when returns were greater, today you have better and far more secure options. Typically, passive investors have been happy with a modest 4 percent return per year, whereas real estate investments can be over 20 percent when leveraged. We’ll get to the numbers soon.
Someone who relies on buying and paying off a primary residence as their sole source of investment income is also a passive investor. Buying a home is a great place to start, but if you stop there, you aren’t using your money to your best advantage.
From Passive Investor To Rockstar
Sarah is a client who wasn’t satisfied with being a passive investor and merely growing equity in her primary residence. She was making $60,000 a year and didn’t like the view she had of her financial future.
With Kyle’s help, she got proactive. She figured out where she wanted to be and took the steps to get there. She saved enough for a first down payment and invested smartly in her own neighbourhood. Then, like clockwork, every few years, she would buy another house that needed a little work. She’d fix it up and rent it out.
By doing renovations herself, she was able to save on labour and also found that she was able to increase her rents substantially due to the upgrades and improvements. There was a snowball effect once she had several properties. Her equity grew as renters paid off her mortgages. Every time she was ready for a new investment, she would refinance one of her rental houses and pull out the money she needed. Her portfolio is worth over $5 million today. She’s a rockstar!
Don’t Wait To Buy Real Estate; Buy Real Estate And Wait
Are you starting to recognize the opportunity in real estate investment? It doesn’t have to be intimidating if you know what to do and start with one property at a time.
It’s not rocket science. You can build a game plan to suit your individual goals and needs, even if you don’t have cash or have bad credit. It may be a little harder, but it’s not impossible. There are options for everyone, and the returns are worth it.
On average, investing in real estate is better than passive investment. The proof is in the numbers. Assuming you put 20 percent down on a $1 million property, the return on your investment (ROI) just from having your tenant pay down your mortgage for you is approximately 8 percent depending on your interest rate. Even if there’s no equity growth and zero positive cash flow, your tenant is covering your expenses and paying down your mortgage at the rate of $16,000 per year.
On the other hand, if the value of the asset rises a conservative 3 percent, your ROI might be as high as 23 percent. Your return is greater because you are leveraging the value of the property. If you only put down 20 percent, or one-fifth of the property value, every 1 percent of appreciation yields a 5 percent return on your money. Three percent appreciation correlates to 15 percent ROI and grows to 23 percent when you add in the other 8 percent created by the tenant’s paying down your debt. For example, if your $1 million property goes up 10 percent, or $100,000, you made $100,000 on your original down payment of 20 percent ($200,000).
Numbers never lie. When you take the time to understand the calculations, you’ll see how quickly your wealth can grow. By actively investing in real estate, you get your money working for you much harder and giving you a much greater return than a passive investment in a mutual fund, which might give you a 5 to 10 percent return in a good year.
You Have To Live Somewhere
Your first investment opportunity should usually be the home you live in. Instead of paying rent, do everything you can to buy your own residence. You’re essentially paying yourself every time you make a mortgage payment. Nearly half of your mortgage payment is principal repayment when rates are low, which is around 3 percent at the writing of this book.
Another important reason to start with your own home is that Canada exempts your residence, but not your investments, from capital-gains tax. For this reason, your home should be the most expensive property in your portfolio. If it’s the most expensive, it’s probably also appreciating the most. Think about it: 10 percent appreciation on a $1 million property is a lot more than 10 percent on a $100,000 property, and you can earn it tax-free.
Appreciation is a good reason to own your own home but not the only one. We all like it when the value of our property increases, but the real benefit of homeownership is that it opens up more opportunities to make money. When the value of your home appreciates, you can leverage your growing equity into a down payment on your next investment.
Making It Pay
There are four ways real estate can make money for you. One may be more appealing to you than the others, but it will literally pay you to understand them all.
Cash Flow
Cash flow is the revenue you realize from your rental property. It’s calculated by subtracting your expenses from your income. Whatever is left in your pocket is your net income or cash flow.
New real estate investors often make the mistake of miscalculating their cash flow. If you calculate cash flow solely as your rent minus your mortgage payment, you’re missing key components. Expenses may also include property taxes, strata fees, insurance, utilities, and property management fees, which can be up to 10 percent of the gross rent. Every house eventually needs repairs, so maintenance should also be included in your expenses as well as a contingency fund for repairs. Finally, you should factor in the vacancy rate in your area. Unless you are in an area with very high vacancy rates, a conservative vacancy rate is usually 3 to 5 percent.
Not all of these expenses will apply to you. For example, your tenant may take care of the utilities, or you may decide to manage the property yourself. Nevertheless, if you’re aware of all the potential expenses, you’re less likely to be faced with an unpleasant surprise. It’s all a numbers game, and you have to get the numbers right.
Cash flow is the key to the castle because it’s the key to financing. When you have positive cash flow, you can hold a property longer, the asset will appreciate, and you’ll see bigger benefits from paying down your mortgage.
Paying Down Your Mortgage
A common reason for not investing in real estate is that potential investors don’t think they can buy a property with positive cash flow, or think they have to gauge the market to buy at a time when the value of the real estate will increase. Most people don’t realize they can earn a good return just from having a tenant pay down their mortgage for them.
Even if your cash flow is zero, your tenant is still making your mortgage payments, and almost half that amount is reducing your principal. When interest rates are low, principal reduction is even greater, and your mortgage disappears more quickly. In 2007, a typical mortgage had a 6 percent interest rate and forty-year amortization. In that scenario, 9 percent of the mortgage payment went to pay down principal. With interest rates around 4 percent and twenty-five-year amortization (at the time this book was written), almost 50 percent of your payment reduces the principal amount.
When interest rates rise, more of your payment has to cover the additional interest, and less is available to pay off the principal. Inflation is a cause of rising interest rates, but even this can have a positive spin for the real estate investor. During inflationary periods, you still own a hard asset. The demand for rentals will rise, and you’re now a supplier. No other investment that we know of will give you this kind of return for the risk involved.
Appreciation
You should never buy a property relying on equity growth, or assuming it will appreciate, because prices and values may rise and fall depending on many different variables. At its core, market appreciation boils down to supply and demand, which are impacted by net migration, local job market, vacancy rates, interest rates, inflation, and so o. Once you learn the basics of researching these factors, you should be able to find areas where your properties will appreciate at a faster rate.
Since appreciation is speculative, the numbers need to make sense at the time you invest. Even so, appreciation of assets is where you will make the most money and where seasoned investors realize the bulk of their return.
Appreciation is leverage, and leverage is power. As discussed previously, you receive the benefit of five-to-one leverage when you put down 20 percent. On a $500,000 property, your down payment is $100,000. If the value of the property appreciates by 5 percent, your ROI isn’t 5 percent — it’s actually 25 percent. Remember that every 1 percent of appreciation equals a 5 percent return on your money when you’ve made a 20 percent down payment, because you just made $25,000 on your $100,000 investment.
This is where the magic happens. The key is that you leveraged your investment. You got a $500,000 asset for an investment of only $100,000. Your return is not based on the amount of cash you put in but on the value of the property asset.
If you need another reason to own your own home, calculate the ROI for your personal residence. When a down payment of only 5 percent is required (as opposed to 20 percent for an investment property), the ratio is twenty-to-one instead of five-to-one. Every 1 percent of appreciation on your home is a 20 percent return on your investment. Using a small amount of money to make greater profit is what we mean by leverage.
Flipping
Flipping properties is what most people think of when they hear about real estate investing. Thanks to television, buying and renovating distressed properties has surged in popularity due to the “before and after” wow factor. Although fun to watch, it usually doesn’t make financial sense to blow out walls and redesign the floor plan.
If you’re interested in flipping properties, look for the home that needs a simple, cosmetic renovation in order to make it more livable — and more marketable. This is called a lipstick upgrade. Most homeowners who paint and replace their hardwood floors before selling wonder why they waited so long. Little changes make a big difference! You want to give buyers what they are looking for without breaking the bank.
Making money with a flip starts with the deal at the front end. You have to find the right property that can be renovated for the right amount. For example, if you can buy a property for $200,000 that you can sell for $300,000, and it only requires $30,000 in renovations, you’re in the ballpark. As a general rule, renovations should never cost more than 20 percent of the property value. Your goal is to increase the asset’s value by a number that’s greater than the amount of money you’re putting in. In this example, your $30,000 is working for you like it’s $100,000.
The Active Investment
If you want to have control over your investments, it’s time to move from being a passive investor to getting active. Real estate is one of the best ways to actively invest in your financial future.
Buying property can make money for you in four different ways: generating cash flow, mortgage pay down, passive appreciation, or active appreciation when you renovate and flip distressed properties for quick cash. It’s not a one-size-fits-all approach, and one investment may benefit you in several ways. Regardless of the payoff, one rule remains true: the longer you hold the asset, the more equity you control, and the more leverage you have.
Real estate is one of the only investments where you can gain control of valuable moneymaking assets with very little investment of your own. The bank isn’t going to turn over the keys unless you have some amount of “skin in the game,” however, so you’ll have to find a way to come up with the cash.
If you don’t have the capital to get started, keep reading. In the following chapters, we will show you several ways to find the financing to fund your dreams.
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To keep reading, pick up your copy of Rockstar Real Estate Investing: Expert Advice for Making Your First Million by Jessi Johnson & Kyle Green.
