Some of the wealthiest people in the world made the bulk of their fortunes through real estate investments. But how is wealth created by investing in real estate?
Here are the most significant driving forces behind real estate fortunes.
Inflation is something we all take for granted. The price of everyday goods increases on a gradual basis, and we have no choice but to pay the increased price. So we don't focus on it much. It's a cost that doesn't discriminate but hits everyone, so what's the point in complaining?
Understanding how inflation affects their employees' ability to provide for their families, many large companies offer a “cost of living increase” each year. Inflation is just a facet of the economy. While averaging 3% per year, the U.S. consumer has seen years of high inflation (12.5% in 1980) and years of low inflation (0.1% in 2008).
For real estate investors, inflation can create wealth consistently and reliably. That's because inflation is a consistent driver of home value appreciation. The monthly payment on a fixed-rate mortgage stays the same for 30 years. Taxes and insurance increase very gradually, if at all. That means that while the value of an investment property is increasing each year thanks to inflation, the cost of owning it is not. The difference is equity — you own a more valuable asset year after year thanks to inflation.
While inflation leads to a gradual increase in the value of your investment property, rapid market appreciation is a huge factor that builds wealth. The price of existing homes increased by an average of 5.4% annually from 1968 to 2009.
With real estate, it's all about location, location, location. If you've done your research and purchased a property where the values of homes increase rapidly, chances are your investment will increase in value year after year without any additional capital expense. This is historically how a lot of people made a lot of money in real estate.
The same principle that works in stock market investing works in real estate investing: Buy low and sell high. Areas of the country, such as parts of California, have seen home values increase much, much faster than inflation.
Annual Rent Increases
Housing is the cost of living. Just as inflation leads to an increase in the cost of groceries and consumer goods, the cost of housing keeps pace with inflation. It's typical to increase rents by 2.5–5% each year due to the effects of inflation. And it's common for landlords to increase rents each time a lease is renewed.
However, as an investor, your costs of owning a rental property don't increase with inflation if your mortgage interest rate is fixed. As a landlord, your rental income increases while your costs stay the same. So your investment property delivers more profit to your bottom line year after year.
“Equity” refers to ownership. In the case of real estate investing, your personal equity is the difference between the market value of the property and what you owe on the mortgage. For example, if your property has a value of $150,000 and you owe the bank $120,000, you have $30,000 equity.
“Forced equity” refers to the wealth created when you buy a property at a discounted price and do work to make it worth more. Typically, you buy a “distressed” property selling for 25–30% less than a comparable property that is not distressed. You spend 10–15% to fix it up (carpet, paint, repairs and some replacement appliances) and bring it up to market value.
Let's say you paid 25% below market value. You then spent 10% to fix it. You just increased your equity (ownership) by 15%.
Another way to force equity is to add features that increase the property's value. Let's say you buy a two-bedroom house in a neighborhood where the rest of the homes have three bedrooms. Adding the third bedroom would bring your property up to par with the market value of the other homes. Assuming you bought it for an appropriate discount (because it had only two bedrooms) and the cost to add another bedroom is less than the difference between your price and the new market value, you have forced equity in the house.
Depreciation is negative in most instances. It means the value of something has decreased.
In real estate investing, however, we're not talking about an actual drop in the value of the property. We're talking about a valuable tax break the IRS allows real estate investors. Each year, you can deduct a percentage of the value of the investment property for its IRS-determined lifespan.
For residential properties, the IRS has said that the useful lifespan is 27.5 years. So, for example, if your property is worth $150,000, you can deduct $5,454 from the rental income derived from the property. Say your net annual rental income is $15,000. Your taxable rental income drops down to $9,546.
What makes this depreciation tax break so financially powerful is that most real estate does not lose value each year. In fact, property values tend to go up over time. That means you get a tax credit on the cost of an asset that may be going up in value, not down.
What's more, depreciation is a tax credit that is on top of property upkeep and other costs that you can subtract from the rental income you get. Depreciation can change a cash-positive rental to a loss on paper. That loss can reduce your other taxable income and lower your tax bill overall.
Leverage is one of the most touted wealth-creation real estate investment strategies. It is the use of borrowed capital to purchase and/or increase the potential return of an investment. As a real estate investor, leverage allows you to make money from an income-producing asset worth much more than your cash outlay. For example, let's say you put 20% down and finance 80% of a $100,000 property. The leverage allows you to benefit from and control the income from a $100,000 property when all you invested was $20,000.
Leverage allows you to “make money using other people's money,” as real estate promoters like to say. In a nutshell, you use the bank's money to purchase the property and the tenant's money to pay back the bank. The spread between what you pay the bank and what the tenant pays you is your profit. If you have $100,000, you could control $500,000 worth of real estate assets rather than buying one $100,000 house with cash.
Be Aware of the Risks
These are the primary strategies real estate investors use to create wealth. Of course, like any investment, there's a risk. The key is to buy smart, manage professionally, and not get over-leveraged.
Real estate investing is more hands-on and time-intensive than buying stocks. It also typically delivers higher gains proportionate to with the increased risk. And unlike other investment choices, real estate is a long-term investment. This is because it's a fixed asset that can't be quickly liquidated and transaction costs are so high. In essence, know the risks and mitigate as much as possible.
You can always try out real estate investing with online real estate crowdfunding services such as Fundrise. Read our review and see how you can make money with Fundrise and its REITs.