50,000 Foot View of Investing
Real estate investing is the common man's path to financial freedom. Fortunately, real estate is also the easiest type of investment to learn and the most forgiving. As long as you buy property in a good location, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases. Also, investment real estate is a numbers decision, not an emotional one like buying a home. Plus, you can have multiple advisors, at no cost to you.
Every time I start something new the enormity of it always seems daunting. For example, about 10 years ago I was living in NYC and decided to change my profession from international sales management to selling investment real estate. While the decision was easy the hard part came when I was choosing a location that would be good for the long term. At first, I was a bit overwhelmed by all that I needed to know. However, as soon as I broke down what was needed into smaller elements, things got much easier. The process of breaking down big tasks into smaller and more manageable tasks is a fundamental concept of engineering. However, I learned this approach a long time before I started engineering school.
As a child, I remembered hearing a saying on The Wonderful World of Disney that has helped me in learning very complex systems thought out my life. The saying was, "Yard by yard, life is hard. Inch by inch, life is a cinch." It sounds simplistic but it always worked for me. This same principle can be utilized to learn real estate investing. In this article, I will start with some basic concepts and I will build on these fundamentals in other articles on our website as well as through other media.
Let's start with what I call the big picture of real estate investing - how do you make money investing in real estate?
The 50,000 foot view of investing in real estate is to buy a property such that rent is greater than the sum of all expenses. See the illustration below.
The overall concept of real estate investing is to buy a property such that the monthly rent is greater than all the expenses. Simplistic, but this is what real estate investing is all about. If you keep the above in mind, you will be a long way down the road to consistently buying profitable properties.
Taxes are a major consideration in any investment decision because it's not how much you make, it's how much you get to keep. One of the many advantages of investment real estate is the preferred tax status which real estate investment enjoy. In addition to deducting all related expenses form your income, you can also depreciate investment real estate. Depreciation is confusing to most people but a very important advantage of real estate investing so I will discuss how it works.
First, a definition of depreciation: "Depreciation is the reduction in the value of an asset with the passage of time, due to wear and tear." For example, if you buy a drill and start using it in your business, over time the drill wears and at some point in the future you will have to replace it. The IRS allows you to deduct a certain amount of the purchase price each year over what they define as the useful life of the drill. The IRS specifies the "useful life" of many such items as drills. Note that the IRS defined "useful life" of a tool is an accounting procedure, not necessarily a reflection of reality. The useful life, according to the IRS, might be 15 years but you could still be using the same device 20 years later. As always, do not equate IRS rules to reality.
For example, the IRS guidelines state that the useful life of office furniture is 7 years. The IRS, allows you to deduct 1/7th of the purchase price per year as an expense on your taxes. So, if you paid $700 for a desk, over each of the following 7 years you are allowed to deduct $100 from your taxable income. The IRS has also defined a useful life for various forms of real estate. The useful life of most investment real estate is 27.5 years (why 27.5 years????). The only significant difference between depreciating office furniture and real estate is that you can only depreciate "improvements" (structures and such), but not the land. The concept is that land never wears out so it is not depreciable. How does this work in practice?
For example, if you assume that 80% of the total purchase price is depreciable improvements (20% of the purchase price is the cost of the land) and we paid $180,000 for the property, you would deduct ($180,000 x 80% / 27.5) about $5,236/Yr. year from the net income generated by the property. The fact that you get to depreciate your investment is huge is I will show you in the following example.
Suppose you owned the following rental property:
- Purchase price: $200,000
- Rent: $1,200/Mo. or $14,400/Yr
- Management fee (8% of Collected Rent): $1,152/Yr
- Property taxes: 0.55% x $200,000 = $1,100/Yr
- Landlord insurance: $450/Yr
- Debt service (30Yr, 20% Down, 4.5%): $834/Mo or $10,015/Yr
- Interest portion of debt service: $6,913/Yr
- Depreciable percentage of property: 80%
- IRS useful life: 27.5 Yrs
- Annual depreciation = ($200,000 x 80%) / 27.5 = $5,920/Yr
Below is a comparison of your taxable income vs cash flow.
|Item||Tax View||Actual Income|
So, to the tax man, your property lost $785 over the year, which you may be able to use to offset other income. However, in terms of your bank account, you received $2,033 over the past year. Below illustrates the difference between cash flow and taxable income.
Another important concept to keep in mind is that each month the principal owed decreases. In the above example, you had a tax loss of $785/Yr, a cash flow of $2,033/Yr plus the mortgage was reduced due to the payments made each month. And, when the mortgage is paid off, your cash flow increases significantly as illustrated below.
In this article, you learned what real estate investing is all about: buying properties such that the rental income is greater than all expenses. I described how depreciation can result in a negative taxable income while still having a positive cash flow. Depreciation is just one of the many advantages real estate investing offers over more traditional investments.