Why Real Estate

Cash flow is the most essential key to achieving financial freedom. Back to my personal journey above, the more money I made from my W2 job each month, and the more monthly expenses grew as my family, house, etc. all got bigger I became more aware that for me ever to be financially free I would need to offset my active income with passive income cash flow.

For me to invest in a real estate deal, the rental income must exceed the monthly expenses considerably. Many investors do this through single-family homes, but I have found that the management overhead of a single apartment community (a multifamily property) vs. many single-family homes is much lower. There is also much more control over the valuation when it is sold as that valuation is based on income and can be increased with strong operational practices rather than waiting on market appreciation. Additionally, cash flow can be achieved much faster, as you would need to buy the equivalent of 8 houses to produce the cash flow of a single 16 unit apartment community.

Equity capture is when you purchase an asset for less than it is worth. When evaluating an apartment community, we always look at market trends, comparable properties, and demographics of the area to determine if there is an opportunity to increase the value. Strategies like rehabbing units and fixing up the exteriors allow us to increase rent on units. We convert non-income producing space to income-producing, charging for premium parking, and other methods. Expenses like utilities can be billed back in proportion to use, which encourages conservative use by residents, thus lowering expenses.

If we can increase the total income on the property by 10%, we increase the property value by 25%, which is typically the same amount of money we have in the deal. This allows us to unlock that equity in several ways and get our original investment out of the deal while we continue to reap the rewards of the ongoing cash flow. We will often continue to improve the income throughout the life of the deal and sell the property than an even higher value at a later date.

Real estate prices are forced to rise over the long term with inflation of building materials, labor, and scarcity of land. Many other investments rely on this as the sole method of producing a return. For real estate, it is merely icing on the cake, not the primary focus.

A portion of the money paid to the bank on the mortgage is typically toward the principal. This is rent money being paid by residents paying down the loan against the property, thus increasing our equity even more. Simply put, even if the market endured some hardships, and we were not creating cash flow on a property for a short period, we are still making money as long as we break even since the principal on the loan is being paid down.

There are many advantages to real estate when it comes to taxes. The IRS allows us to reduce our earned income tax on cash flow by taking a depreciation deduction against the property. There are many strategies that can be employed here, such as accelerated depreciation through cost segregation to provide even more tax relief. Additionally, there are strategies that can allow us to convert passive income to active income from a taxation perspective allowing these “losses” to flow through and reduce other taxable active income.

We can also avoid capital gains tax when we sell by using a 1031 tax exchange. This is less common in syndicated apartment communities, but still possible. Additionally, if we pass the property to our children, they will take over at the new cost basis, which wipes out all of the capital gains over the life of that asset.

This last point is an important one, so even though it is a less talked about topic, it is a significant one that makes real estate a vehicle that produces returns only otherwise seen by the ultra-wealthy.

I was working at a publicly-traded company some years ago, and after a change in market conditions, there were rumors that our company was going to be sold. Many months later, the company announced that a private equity company was buying us. When the new management team took over, I remember watching the CFO do a presentation where he illustrated that this purchase was through a leveraged buyout. He explained the process similar to taking out a mortgage to buy a house. The big difference is the income-producing power of a multi-billion dollar company is much larger than a house.

The process of real estate investing is very similar. As an investor, I am only putting in 25% of the cash on a commercial property, but I am keeping almost 100% of the profits (minus any paid out to other investors if the deal is syndicated). The fantastic thing is, we are generating profits on 100% of the asset’s income-producing power, even though the bank has paid for 75% of the asset. They simply collect their very low-interest rate off the top, and the property owner, often tax-free, keeps the rest!