Your real estate pillars of wealth typically begin with your home, assuming you own it. Over time you may add properties to your real estate portfolio. Additions may include a second home or properties rented to other families or businesses.
Home ownership is appealing for several reasons, including:
- Real estate is tangible—we can touch it and know it’s there
- While real estate can decline in value, it’s generally a reliable long-term appreciating asset
- Real estate can be a decent defense against inflation
- There may be favorable mortgage interest deductions for homeowners
While owning a home gives you a pillar of wealth, it also saddles you with long-term managerial and financial responsibilities as a property owner. These downsides are discussed in the debt management chapter.
Real Estate as an Investment
In addition to (or instead of) owning your own home, you can purchase a property as an investment and rent it to others. Here are some reasons to consider real estate as an investment:
- Capital Gain – Capital gain is the profit from selling the property at a higher price than the original purchase price. You don’t pay taxes on capital gain profits until you sell the property, so there’s an element of tax-deferral in real estate investment
- Tax Deductions – many rental property-related expenses are deductible, allowing you to reduce your tax obligation. Examples may include: property taxes, management fees, repair and maintenance costs, as well as mortgage interest payments
- Depreciation – you can depreciate a percentage of the property value from rental income each year. This reduces your tax bill in that year
- Accumulating Equity – the tenant’s rent payments help you to pay off your mortgage and steadily build equity in the property. Due to the structure of amortization schedules, most of the early monthly payments go toward interest, with only a small fraction going toward reducing the principal and building equity. But as each month and year goes by, more of each payment goes toward paying the principal, and equity buildup accelerates. (As this shift from interest to principal occurs, your available interest deductions may decrease)
- Cash Flow – when your income from a property is consistently greater than all expenses on the property, it is said to generate “positive cash flow.” You can direct this cash flow into retirement accounts or accumulate it until there’s enough to make a down payment on another property
Successful real estate investors are good at identifying properties that yield positive cash flow and use those flows to purchase a portfolio of properties. Once you reach a critical mass of properties, you can attain some economies of scale and control your expenses even further. For example, when you own only one rental property you may have to pay a plumber a large amount for each service call. But with ten properties you can strike a deal with a local plumber to take care of all your properties at more favorable rates. The same goes for all maintenance personnel (electricians, landscapers, tree experts, etc.).
Being a Landlord Isn’t for Everyone
It’s easy to get caught up in the excitement of making passive income through real estate, but it’s not as glamorous as it seems. Many people, after learning hard lessons, decide this isn’t for them.
Some of those downsides:
- If you’re buying property with a view to renting it to others, you take on all the landlord headaches. Your phone may ring in the middle of the night with complaints from your tenant about an overflowing toilet, broken appliance, or flooded basement. Do you really want to take those calls?
- As a landlord, you rely on incoming monthly rent to pay a mortgage. Whenever the property is vacant, you have to cover those mortgage payments yourself. This can be a heavy strain on your household finances
- Tenants may cause damage to a property and/or they may refuse to pay rent, forcing you to go through an emotionally painful and financially expensive eviction process
Before becoming a landlord, carefully consider the anticipated expenditures, headaches, and distractions.