Financial planning for financial independence

Content, resources, and services to help people make intelligent decisions with their money in route towards financial freedom

The Magic of Real Estate

Over the course of the past two to three years, I have been on a quest to really sink my teeth into the world of real estate investing.  By this, I am not talking about REIT's (Real Estate Investment Trusts) that can be easily bought and sold like stocks; but rather, true, physical real estate holdings.  After plenty of analysis (and some paralysis), I finally ventured out and bought my first property in April.  This led to a handful of other properties along the way, which has been a rather exciting journey.

My primary financial objective to owning real estate is to build up a stream of passive income.  That being said, it is imperative that all my properties are cash flow positive, net of all expenses (principal and interest, insurance, taxes, management fees, operating and capital expenditures).  While cash flow is fantastic, the magic lies underneath the hood as you dig further into the numbers.  For example, one of my properties was purchased for $85,000 and rents for $1,150/month.  Here is a complete breakdown of the monthly cash flow on that property:

Inflows:  Rent = $1,150

Outflows:  Principal and Interest = $323, Taxes = $223, Expenses/Vacancies = $173, Management Fees = $115, Insurance = $45

Total Net Cash Flow:  $271/month

This equates to a net yearly cash flow of $3,252.  With a 25% down payment and closing costs, the initial down payment was around $25,500.  This equates to a 12.75% cash on cash return in year one.  Not bad! 

But again, that is just the return on cash flow.  Over the course of 30 years, the loan balance of $63,750 is being paid off by someone else at an average pace of $2,125/year, or roughly $177/month (amortization schedules don't work in linear fashion this way for loans, but for the sake of simplicity, let's assume it would).  Adding that $2,125/year to your original cash flow, you now have a year one return of 21.09%.  Even better!

Yet another item we have to take into consideration when it comes to real estate is appreciation on the property.  Historically, real estate has appreciated around the same rate as inflation (around 3-4%), but being conservative, let's assume this property only grows at 2% per year.  For the $85,000 value, that would equate to $1,700 in year 1.  Adding this to our cash flow and loan pay down, we now have a year one return of approximately 27.76%.  Are you excited yet?!

But the story only continues to improve on the above.  There are tax advantages for owning real estate as well.  In addition to getting to write off all expenses associated with managing and maintaining the property, you also get to take depreciation on the value of the structure.  In this instance, the value of the actual structure or dwelling (not the land) came in at $65,000 on my initial appraisal.  Using a 27.5 depreciation schedule, I am able to also deduct $2,364/year of income over the first 27 1/2 years.  Considering my property nets $3,252 a year, I will only have taxable income of $888 for the year.  This keeps my income stream high and tax bills low.  Who doesn't love that?!

Of course, all this being said, there are risks involved with owning real estate that are different than your traditional stock and bond investments.  You may land a horrendous tenant or have an accident happen on your property, in addition to a multitude of other items.  So make sure to property educate yourself (through books and resources such as Bigger Pockets) and protect yourself (through insurance and legal entities), and have ample cash reserves on hand for any repairs and maintenance that will come due.

It's best to think of real estate as another diversifier in the whole of your net worth.  A balanced approach tends to always prove to be the smartest approach.