Updated: Sep 4, 2018
Have you heard stats such as “80% of millionaires attribute their wealth to real estate”? Or heard stories of living the good life off passive cash flow from rental property? Combine this with the recent years of unpredictable, disappointing stock markets, and you get masses of people realizing they have no control over many of their investments and therefore their life savings. Tired of blindly following the crowd of 401K stuffers, many have started looking at why so many wealthy people own real estate. In this article, I will break down the numbers in the simple yet rarely talked about truths behind the wealth building abilities real estate carries.
Who doesn’t love to focus on the wealth and freedom real estate can give you? We all love it so much, we forget to explain how it does this. This void in education leads people jumping in not realizing that even some investment strategies within real estate do not carry the benefits of others.
Going to meet ups, listening to podcasts, or reading articles, you frequently hear about people building wealth and the successes they have accomplished through owning investment real estate. What we forget to ask is why and how owning investment real estate is able to make this happen so much better than other investment strategies, including flipping, stocks, private lending, and any other form of investing. In this article, I will answer that very question.
Why I Focus on Multifamily
When it comes to real estate investments, I focus in multifamily apartment complexes because of the control it provides in determining the investments results. Some of the most powerful factors in real estate are control, debt (leverage), and taxes. For the average investor, leverage is commonly used in real estate, but not in stocks or private lending. In addition, the IRS and owners of investment rental property might as well be best friends because the IRS has made so many rules to benefit us.
There is a lot of useful information packed into this article. You will have to read this article slowly and maybe even a few times. If you don’t know a term, stop and look it up. Stop to understand the math. Even though there is a lot of math, it’s only addition, subtraction, multiplication, and division. I actually wrote this article on my iPhone using the iPhone calculator, so don’t let the math overwhelm you. Once you truly understand all of the words and math behind it, you will see how simple it really is to build wealth in real estate and why our wealthy continue to attribute their financial freedom to real estate.
The best way to illustrate the truth is through math and examples. Rather than look at the same old surface results, we are going to drill way down into why all these millionaires attribute their wealth to real estate — and specifically multifamily and other commercial real estate investments.
Today, You’re Buying an Apartment!
You put a $200k down payment on a $1M building at a 8% capitalization rate (very achievable). This leaves you with $80k net operating income ($1M x .08). When you borrowed the $800k from the bank, they lent it to you at 4% interest with a 30-year amortization. This means your year one mortgage payments equal $45,832 ($31,744 interest, $14,088 principal), leaving you with $34,168 in cash flow ($80,000 – $45,832) or a pre-tax cash on cash return of 17%.
But wait, there’s more!
So if you cash flowed $34,168, do you pay tax on $34,168? NO! Another beauty of real estate and leverage is the depreciation tax benefit. This is one the benefit the IRS has given to their buddies who are real estate investors. Even though you only put 20% of the $1M into the property, you get ALL of the depreciation benefits.
Apartment buildings are depreciated over 27.5 years, which means you get to depreciate the building’s value. The building’s value does not equal the property value because the building sits on land, and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value that is allocate to land value is 20%, or in this example, it would be $200k. This leaves you with $800k of building value to be depreciated, so $800k/27.5 = $29,090.
What does this mean? It means you barely pay any tax on that $34,168 cash flow you made on the building. You actually only have a taxable gain of $19,166 ($34,168 cash flow + $14,088 principal portion of your mortgage payment – $29,090 depreciation). We add back the principal amount of your mortgage payment because it is not a tax deductible expense and subtract out the deprecation we listed above.
Since you were able to put $200k down on a property, I’ll assume you’re doing pretty well financially. Because of this, I’ll even venture to guess you’re in a 35% tax bracket. Since your tax bracket is 35%, the taxable gain of $19,166 would result in cutting a check for $6,708 to the IRS, leaving you with $27,460 ($34,168 – $6,708). This means your after tax return is 13.7%.
This is where most people shut off the brain and say, “My financial advisor says I can earn 8% in a mutual fund, and those have no tenants, no managing the property manager, no headaches. That peace of mind in itself is worth not owning real estate, right?” NO, not true at all! There are more major pieces to this puzzle that the wealthy use that so many that give up at this step never see.
How to Use Taxes to Your Benefit
Let me jump back to the taxes, specifically depreciation. Another tool our buddies at the IRS gave real estate investors was a cost segregation study. They found out we like depreciation, and so they gave us more!
In accountant talk: A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations. In normal person language, this means the IRS lets you accelerate deprecation on things like cabinets, appliances, carpet, light fixtures, and other parts of the building. This forces more tax savings to the investor sooner.
Rather than try to break down all the different parts of the cost segregation and their deprecation rates, I’ll just give a round number of what a cost segregation study would do for you and this example. You really don’t have to know the nitty gritty on how to do them because you will hire a professional to do it for you.
For our example, doing a cost segregation study would increase the total depreciation allowance by $10K. Nice! This means we can adjust the above math to now look like this ($34,168 cash flow + $14,088 principal portion of your mortgage payment – $39,090 depreciation). So now our taxable gain was only $9,166, which also reduces the amount we have to pay the tax man to $3,208 ($9,166 x 0.35). Even though you put $34,168 into your pocket, the first year you only paid $3,208 in tax. This means you, Mr. 35% Tax Bracket, only had to pay a 9% tax rate on your income! I told you the IRS and real estate investors are buddies, so their always trying to find a way to help us out! Because of this, your after-tax cash-on-cash return is 15.4% ($30,960/$200k).
You’re thinking, “Hmm, 15.4%. Maybe this kids on to something.” We’re just getting started. Read on.
The Power of Debt
A huge difference between other investment classes and owning investment real estate is the power of debt. With most debt comes amortization. Wealth is built in the amortization of the debt you put on the property. Back to our example, the $800k in debt you put on the building will have an army of tenants paying down your mortgage month after month. This is amortization.
Now let’s wrap the amortization into our example. Using the loan terms I mentioned, the first year of the loan will result in a $14k reduction in the amount you owe. If the property value stays the same, that can also be seen as a $14k increase in equity. If we add that $14k to the after-tax cash flow, we are left with an all-inclusive after-tax return of 22.4%.
In this example, we assume the value of the property will not go up in value one cent — which is smart because assuming is another word for speculating, and speculating is risky investing. However, in multifamily (5+ units) or other commercial investment real estate, the value of the property is based on the income the property produces. The wealthy love to control things — this is exactly why the wealthy focus on commercial property such as multifamily apartment complexes.
Being that you control the income and expenses in a property, you also control the value. What this means is if you have a way to increase income either by raising rents, billing residents back for utilities, or adding any other source of ancillary income to the operations of the property, you will also add value. Also, the flip side of the equation is if you decrease expenses by renegotiating operating expense costs, billing residents back for utilities, reducing turnovers and vacancy, putting in energy efficient light bulbs and plumbing fixtures, or ANY other way to cut operating expenses, you increase the value of your property.
Increasing Multifamily Value
So let’s look at our example one last time. Say this $1M building was a 20-unit apartment complex. The reason you bought this complex was because you’re smart and you saw opportunity in it — the opportunity to add value by both increasing income and decreasing expenses. Nothing major, just a few things you could do right after purchasing to help the bottom line.
Before purchasing, you noticed that the previous owner had owned the building so long, they had not been keeping up with market rents. You noticed similar units in your area rent for $900-925, but yours were only renting for $850. Being that all the residents were on month to month leases, you went ahead and implemented a minor $25 a month increase in rents to all units in month one. You wanted to keep rent below market so you wouldn’t lose your residents but thought that was still fair to everyone. This added $5,700 (20 units x $25 x 12 months – 5% vacancy allowance) of income to your bottom line annually.
Another opportunity you wisely saw was in vendor costs. Over the past 20 years, the vendors had slowly crept prices up above market rates for their services. The previous owner was comfortable with the properties operations and had a good relationship with his vendors so they never bothered to check the going market price.
Day one of owning the property, you were able to negotiate the following monthly expenses down:
Monthly dumpster fee from $110 to $95 — an annual savings of $180
Per cut grass cut expense from $150 to $100 — an annual savings of $1000
Property management fee of 8% down to 7% — an annual savings of $1,600
This all doesn’t seem like much, and was really simple to do. Let’s see how it affects the returns in our example.
After increasing income $5,700 a year and simultaneously decreasing expenses $2,780 you were able to increase the money you put in your pocket $8,480. The extra cash is nice, but the real power behind this is the fact that commercial real estate is valued based off the income it produces. Since you increased the income the properties produces, you also increased its value.
Let’s look at how this affected our example. Your property still is in the same market and asset class that awards it with the same capitalization rate of 8% that you bought it for. Now that you have found ways to add $8,480 to the net operating income, this gives you a total net operating income of $88,480. By dividing the net operating income by the cap rate, we can find the new value of the property.
$88,480/.08 = $1,106,000.
That’s right! Making those minor changes increased the value of your property $106k.
Your mortgage didn’t change, so you still owe the same — you simply raised the equity you have in the building $106k without putting a single dollar more into the investment.
New & Improved Totals
To find what the all inclusive return is now that you have added value, add $8,480 you your taxable income, which will result in an additional $2,968 due to the tax man. This takes your new and improved total after tax cash flow to $36,472 — or an after tax cash on cash return of 18.2% Add in your total $120k equity accrued in year one ($14k from amortization and $106k from forced appreciation), and you have an all inclusive return of 78% (($36,472 + $120K)/$200k).
Now that you found a way to make all this money, you may be thinking the taxes will hit hard once you sell the property. My first response is, “Why sell it?” This is a fantastic property. Hold on to this cash cow, milk it, pull all the equity out in a cash out refinance, which is not a taxable event, put it in a trust, and hand it off to your heirs.
Or if you love the velocity of money and are looking for the biggest bang for your buck, sell it. But do so in a 1031 exchange, which defers all tax into the next property purchase. Do this until you die, and the taxes die along with you.
And that is how the wealth is built in real estate.