Why Real Estate?
According to The College Investor over 90% of the world's millionaires created their wealth by investing in real estate. Why did they choose to invest heavily in real estate as opposed to traditional investment instruments (stocks, bonds, 401Ks, CDs, etc.)? In this article I will compare the fundamental difference between traditional investments and rental real estate income streams.
Traditional Investment Instruments
The traditional investment concept is to accumulate enough capital so you can later draw-down (withdraw) funds over a period of time. For example, suppose you plan to withdraw $5000/Mo. (present value) for 30 years and there will be zero inflation, zero transaction fees, zero taxes and zero capital appreciation on your investments. If this is the case the math is easy:
30 Years x 12 Months/Year x $5,000/Mo = $1,800,000
However, the assumption of zero inflation, zero transaction fees, zero taxes and zero capital appreciation are not realistic. Since most secure investments are paying less than 2% (CDs, etc.) and, depending on who you believe, inflation is between 3% and 6%, in a best case scenario you will lose approximately 1% per year. If this is the case, then you need to accumulate more before you start to draw down. For example, if you expect 3% net gain during the 30 year draw-down period, you would need approximately $3,000,000 to be able to draw $5,000/Mo. for 30 years. Also, what if you or your spouse lived longer than planned? This could be a serious problem that many people face because at the end of the draw-down period you have zero money left. Simplistically, the problem with traditional investment instruments are:
- You must consistently select the right mix of investments that will beat inflation. Note that even the best money managers have a problem consistently achieving this goal. Plus, every time you trade, you pay taxes and fees further reducing your working capital.
- You need to know in advance how much you will withdraw (in current value dollars) each month.
- The total draw-down period.
- The inflation rate over the entire time you will withdraw funds.
- What taxes and transaction fees will be in the future.
Don't forget that at the end of the draw-down period you will have zero funds remaining so if you outlive the draw-down period or have higher inflation or taxes than expected, you might be in trouble.
Real Estate Income Streams
With real estate, you accumulate sufficient income streams over time such that the aggregated income streams meet your income needs. For example, assume that over time you purchase properties and each generates a cash flow of $250/Mo (after all recurring expenses and not counting tax advantages). If you goal is $5,000 per month, you need $5,000/$250 or 20 properties. This example is overly simplistic but the concept is correct.
How much would it cost to purchase 20 such properties? Ignoring inflation, tax advantages (which are huge with real estate) and appreciation and assuming each property costs $180,000 and you obtained 30-year financing with 20% down at 5% interest, you will need about $36,000/property plus another $12,000 (to cover closing costs, rehab, etc.) or approximately $50,000/property. Simplistically, you need $1,000,000 (20 x $50,000) to establish a near perpetual $5,000/Mo income stream. Also, since rents have historically tracked inflation while your largest cost is fixed (debt service) your real income (present value) actually increases with inflation. Also, cash flow significantly increases once the mortgages are paid off, as illustrated below. With reasonable management, the income stream will be available for your children and their children. There are families in Europe and Asia who have been living off rental income from properties purchased hundreds of years ago.
To me, the almost perpetual income stream real estate generates and the huge tax advantages are the greatest advantage over any other type of investment. One last advantage of real estate that as long as you buy investment real estate in a good area, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases. You can even sell the property and, if you do things correctly, continue to deffer taxes.
In this article I explained the basic differences between traditional accumulate and draw down investments (stocks, bonds, CDs) vs. accumulating income streams with real estate.