If you talk to a financial advisor, she’ll tell you to invest in stocks. When you talk to a real estate agent or broker, she’ll tell you to invest in real estate. I’m one of those people who believed you could and should do both. So I did. In terms of building a stronger nest egg, real estate wins hands down.
There are many reasons to invest in real estate:
Cash Flow in Retirement
Lets say you own one rental property. Tenant pays the rent and thereby pays off the mortgage by the time you’re age 65. You can then use the passive income from the rent to supplement your retirement. Income from Social Security and 401(k) can cover the rest of your expense while you enjoy retirement in style.
Appreciation
Home prices generally appreciate by an average of 3% per year. Therefore, housing is a good hedge against inflation. The value of properties can go down at times but it doesn’t compare to the volatility of the stock market. You can also force appreciation by improving the property through renovating it. As your property increase in value so does your net worth.
The current value of the property-current mortgage=net worth.
Tax Benefits
You can deduct the interest, property tax, and other expenses that you incur to operate a rental property. Furthermore, when you sell your income property after minimum of one year, you pay tax capital gains tax. This is usually lower than your income tax. Finally, you can defer paying taxes altogether if you do a 1031 exchange.
Depreciation
You can depreciate the value of property or building (not the land value) over a period of 27.5 years. Look at the appraisal report or the tax assessment to get this information. If your cost basis in a rental property is $200,000, you can annual depreciation expense of $7,273. This can be a huge tax write off while you’re working and earning an income.
Real Estate as an Inheritance
Income property is an excellent asset to pass to your children or grandchildren to build generational wealth. There are many tax benefits, including step-up in basis rule. This rule is applied to the coast basis of the property transferred at death. For example, lets say your children inherit your home that you purchased for $200,000. The value of the home at the time of their inheritance is $600,000. If they sell it close to $600,000, they would not incur capital gains tax. If they hold onto it for some time and sell it for $800,000, they would owe capital gains tax on $200,000 instead of $600,000.
Leverage
Money
You can leverage money. I purchased my first home for $200,000 with a 5% down. When the property doubled in value, I did a cash-out refinance. This was perhaps the easiest way I ever got $120,000 into my hands. I used this money for a down payment on another house. I was able to get rid of the private mortgage insurance (PMI) by refinancing.
Real estate is the best layaway plan ever. Unlike a traditional layaway plan that you have to complete the payment before you get the product, with real estate, you can leave with the item with just 20% payment or less.
Other People
When you invest in real estate, in addition to using other people’s money (OPM), you can also leverage other people’s time and experience. When investing in real estate with partners, seek others who can contribute with their time and experience. You can build a strong team with a realtor, accountant, contractor and an attorney who are also your partners.
Pay Down Principal
Your tenant pays down the principal. As the principal shrinks, interest payment also decreases while the equity and your net worth increases. This is the reason why you don’t want to refinance too often. For a 30-year mortgage, at year 17, the line crosses between where you start paying more towards the principle instead of interest. If you refinance during this time, you will start a brand new cycle of paying more interest rather than the principle. This is often the reason why you will get inundated with mortgage refinance offers around this time.
See graph from moneychimp.com.
Equity
Building an emergency fund is sensible and necessary. Yet, it is difficult to cover all the expenses, contribute to retirement, and save for a rainy day. For some, it is a nearly an impossible endeavor. Investing in at least one real estate property can help you get ahead.
My three partners and I owned a condominium that for whatever reason had a high tenant turnover. In spite of this, we sold it at the height of the market and each made $20,000 profit. I was finally able to pad my emergency fund with the profit.
More Fun and Control in Real Estate Investing
Investing in real estate is certainly more fun than watching the stocks go up and down. You can take an ugly duckling and turn it into a swan. The anticipation of improving a property gets me excited each time I purchase a house. Similarly, buyers were happy and grateful each time I sold a property.
Option to Change Primary Residence
Investing in real estate also gives you the option to change your primary residence later in life. Lets say you purchased a starter home. Then you rented it out and moved to a larger home to accommodate a growing family. After you raise your kids and they leave the nest, you want to down size. Now, you can move back to your starter home. If your tenant paid it off completely, you wouldn’t have to worry about a mortgage or rent. This can release a lot of financial pressure off during your retirement years.
Mitigate Risk
Having a rental property in your portfolio adds diversity to your investments. If there is a decline in the stock market, having a different investment in your nest egg can mitigate your overall risk by offsetting the focus on just one type of investment.
“I will forever believe that buying a home is a great investment. Why? Because you can’t live in a stock certificate. You can’t live in a mutual fund”
– Oprah Winfrey