You’ve probably seen the late-night infomercials, reality TV shows and get-rich-quick books on real estate investing. Most focus on buying properties for peanuts, making a few minor cosmetic upgrades and flipping the property for big bucks. Unfortunately, for the average investor, it seldom works this way.
The reality is most real estate investing is not this quick or glamourous. A common misconception about real estate investing (at least partially due to these media sources), is that an increase in property value is the only way to make money in real estate. While that is certainly part of the equation, real estate has the potential to build wealth in certain market conditions through the following ways:
- Cash Flow
- Principal Reduction
- Tax Benefits
Like a bond or dividend-paying stock, well-leased properties have the ability to generate consistent income. Assuming rents received from tenants are sufficient to pay all operating expenses and debt payments, the excess cash flow provides a return on equity invested. Depending on the property type, tenant leases may be for multiple years, providing an investor with recurring income.
As mentioned in the opening, price appreciation is the source of return that often receives the most attention. Although property values can decrease on a year-over-year basis (as witnessed during the global financial crisis), commercial real estate has historically demonstrated value appreciation in excess of inflation over the longer term. In fact, since the National Council of Real Estate Investment Fiduciaries (NCREIF) began tracking private commercial real estate returns in 1978, the NCREIF Property Index (NPI) has exceeded inflation (as measured by the Consumer Price Index (CPI)) in 32 of 38 years through 2015.
Given the dollar amounts involved, investors often finance a portion of the investment. Debt enables investors to acquire larger assets and also has the potential to magnify cash-on-cash returns. Debt can also provide equity build-up through principal reduction. Assuming a property’s net income is sufficient to cover its debt payments -- and that the loan is amortizing -- then an investor’s equity in the property will increase as debt is paid down. Investors should carefully assess their investment and personal risk tolerance when using debt as debt increases the risk of an investment and has the potential to magnify losses in the same manner it can potentially magnify returns. For greater detail on the risks and benefits of using debt in a real estate investment, see our blog: How Does a Mortgage Affect Real Estate Investor Returns?
Properly structured real estate investments can also provide tax benefits. Cash flow can be sheltered through income tax deductions from interest payments and depreciation allowance, and upon sale of the asset, capital gains can be deferred through a 1031 exchange. These tax advantages leave more money in investors’ pockets than investments without such tax benefits. Finally, through proper estate planning, real estate can be passed down to your heirs, resulting in a generation wealth transfer. See our blog on Tax Benefits of Real Estate Investing to learn more.
Real estate provides multiple avenues to generate income and build wealth. But just like any investment, real estate does have risks. The attributes listed in this article are generalizations and investors should conduct their own analysis and due diligence prior to making investments.To view a variety of passive, 1031-qualified real estate investments, visit the Realized Marketplace.