Investing Real estate

Why should you invest in real estate?

How I Learned About Real Estate

Growing up, real estate was a mystery to me.

My parents never owned their own home, and when we weren’t living with my grandparents we were renting. My mom talked about buying a house at one point and started looking at houses, but we never had the money to make it happen. Home ownership seemed totally out of reach.

Because I was ignorant about real estate, I was always afraid of it. All I knew was that buying it meant a huge amount of debt, and real estate had been a huge factor in causing the recession when I was in high school.

I’d heard all the horror stories about people losing everything by buying real estate. I’d heard about how dangerous it was. I’d heard that being a landlord meant calls at 2 am and tenants breaking things. I’d heard about mortgage notes being called and people losing everything.

With all the terrible things I had heard, I couldn’t understand why so many people still bought real estate.

What I hadn’t heard was a success story.

Then I met one.

My Friend the Millionaire

I had a friend of a friend that I’d always hear talking to people about real estate. I thought he was chasing a get rich quick scheme and usually didn’t stick around long enough to hear more than a few words in passing.

Trouble was, I was forced to be around him once a month without much to do besides listen.

When you have to sit around for long periods of time, you tend to listen to anything anyone has to say even if you don’t care at first. Eventually, I realized the reason he was always talking about real estate was that he was a real estate investor.

The big moment came for me when I found out that he wasn’t just blowing smoke. He owned over 50 properties and was grossing more than $300,000 a year in rental income.

The reason he was always talking about real estate when we were together was that he was genuinely passionate about his business, and he wanted to share how he was making money with people who were willing to learn. I decided that I needed to sit down with him and see what he had to say.

I asked if we could meet, and he immediately agreed.

A couple weeks later I went to his office with my wife and talked with him for about two hours. I still had a lot of fears and doubts about real estate, but he gave me thorough answers about how he got started and what he did to make sure he was successful.

He bought his first property when he was 19 and working at a dead-end job, right before the market fell out from under him for the recession. Instead of selling at a loss, he just kept making payments and saving everything he could.

A year later, he bought another property and rented out the first one. A year after that, he bought another. He kept buying houses until he could buy more than one at a time and he had accumulated over $5,000,000 in real estate. During that time, he quit his job, earned his realtor’s license, and started managing properties.

Like I said, he was eager to share how he made money with others. If you used him as your agent and bought a rental property, he would give you a discount to manage it for you. He would keep giving you that discount every year you bought a new property. Last I talked with him, he had started partnering with developers to build apartment complexes.

I Was Inspired

After talking with him, I wanted to be like my friend.

But more than that, I was impressed by how much he was doing to make sure he covered his bases. He was thorough and had a plan laid out for how he would manage every risk involved with his investing. He knew where to find deals, how to capture cash flow, how to find good tenants and keep them, and make sure tenants didn’t destroy his properties so he didn’t have to evict them.

I decided I wanted to be like him.

My wife and I spent the next few weeks talking about what he had told us, and then went back to him with follow up questions.

I wish I could say that we left that meeting ready to buy our first investment property, but the truth is that we weren’t in a position to start right away. We did go over the kind of property that would be a good fit for us and looked at a few, but we ran into a snag. We had enough income to cover our potential mortgage payments during the summer, but we wouldn’t be able to do it during the school year when we had to reduce our hours.

Much to our disappointment, we decided to shelve our real estate investing until after we graduate and I’m working full time. That said, my experience talking with my friend gave me a few reasons why I’m planning on owning real estate in the future.

Why I Like Real Estate as an Investment

One big reason I plan on owning real estate is the possibility of a phenomenal return based on your cash investment.

Although I’m opposed to debt, I do view debt used to finance a real estate investment that is cash-flowing from day one as an acceptable debt. I do not, personally, believe in the idea of “good debt.” In my view, all debt is bad debt, but I can accept this kind of debt because it provides an opportunity to obtain a true asset.

There was a lot in that last paragraph, so let me break it down a little.

Defining Real Estate Investments

When I say cash-flowing I mean that the investment is providing free cash flow from day one. Free cash flow is the cash provided by the investment after all liabilities and expenses are paid. For real estate, that means the mortgage, property taxes, homeowners insurance, utilities, maintenance costs, etc.

Any rent you collect should be above all those expenses, and I recommend you have conservatively high estimates on all of them so that you don’t get caught with your pants down.

When I say acceptable debt, I mean that I recognize that debt is a form of risk and should be recognized as such, in addition to the principal owed and interest payments due. I feel most people fail to factor that risk into their calculations as a cost of their capital, and erroneously classify debt as “good” so long as it allows them to do whatever it is they want to do with it. I feel that this is naïve and immature.

When I say true asset, I’m mostly following the definition of an asset Robert Kiyosaki uses in his book Rich Dad Poor Dad. Kiyosaki’s definition is that an asset is anything providing you with additional income that you do not have to work for.

If you cash-flow $300 a month on your rental, after all your expenses and saving for future maintenance, you have a true asset. A home you live in is not an asset.

An Example of the Power of Real Estate

Going back to the cash on cash returns that real estate provides, let’s use an example.

Let’s say I have $10,000 to invest.

In scenario A, I invest that $10,000 into the stock market through an index fund. This year the Dow is up 8.69%. For this example, I’ll assume that it matches that return over the rest of the year and the next five years, at which point I’ll cash out my investment. At the end of five years, I’ll have averaged an 8.69% return and get $15,168.69 for a total return of 51.69%.

In scenario B, I use that $10,000 as a down payment on a single-family 3 bedroom 2 bathroom, 2,000 sq/ft house with a current value of $200,000. With a 3.89% rate, which is relatively average for my current market, my mortgage payment is just shy of $900, so we’ll round up. A comparable home in my market would rent for approximately $1,500 a month, or $18,000 a year.

Let’s assume that, after my mortgage and all other expenses I’m able to cash flow $150 a month, or $1,800 a year. In addition to that $1,800 in year one, I also receive $3,404.48 in equity due to my tenant paying down my mortgage for me, leaving me with a return of $5,204.48 for the first year.

Let’s say that at the end of year five I sell my property for $200,000 and cash out. My mortgage balance at sale would be $167,434.98, leaving me with $16,565.02 in cash after a 3% sales commission to my agent. In addition to that, I’ve also collected $1,800 a year for five years for a total of $9,000 to add to my return. My real estate investment would have yielded me $25,565.02 for a total return of 255.65%, or 51.13% per year.

Such an astronomical return on my initial cash investment is only possible because of financial leverage and is one of the greatest reasons to choose real estate as an investment tool.

Closing Points

I want to point out that I wouldn’t turn down the chance to get an 8.69% annual return, and I don’t think you should either. Don’t discount a solid return because you’re chasing a phenomenal one.

I also want to point out that my example had several assumptions built in. You can drastically change the outcome of my example by tweaking just a few things, and you shouldn’t view real estate investing as a no-brainer that will never go wrong.

On the contrary, the last recession showed us that there’s a whole slew of things that can and will go wrong if you’re not prepared for them. You need to fully understand the risks, particularly when you’re using debt as an investment tool.

You need to be well informed about what kind of investment strategy you’re trying to pursue. I favor a buy and hold strategy, but that doesn’t mean you should.

As a last point, if you’d like to learn more about real estate, I recommend the book Building Wealth One House at a Time by John W. Schaub. I’d also recommend having a listen to the Biggerpockets podcast.

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