Benefits of Investing in Real Estate and How You Can Earn Money From Real Estate
Note: this is Chapter 1 of an entire guide on Why Real Estate Investing?
Among the many benefits of real estate investments is the ability to gain both consistent cash flow (read: income) as well as capture long term gains through appreciation. In the best cases, you earn both income and appreciation jointly. Of course, this will vary from investment to investment, but this guide will explore the possibilities and leverage that you will have.
Income from Rental Payments
Rental payments attribute the income piece of residential real estate investments. Owning a single-family home makes you a landlord with a tenant, who pays you money to live in the house.
Ideally, you would like to have your rent exceed your mortgage payment and other fees associated with your rental home. Many real estate investors use "The 1% Rule" to determine quickly if a home will be able to do this. The 1% Rule means that you can earn 1% of the purchase price in rent each month. However, the 1% Rule is an estimate and there are other factors that may increase complexity.
For example, if you bought a $100,000 home with a loan of $80,000, your mortgage payments would be able $500 per month. Using the 1% Rule, you would want to be able to rent the home for $1,000 per month, which allows you to cash flow $500 per month.
In the short term, this means that you are able to generate an additional $500 per month. Practically, this is like buying yourself a monthly $500 raise!
Being able to cash flow properties is one of the most attractive parts of residential real estate that is not offered in other investments like stocks and bonds, especially at the return that residential real estate may offer.
Let's look at a real example: Consider a home purchased for $150,000 with a mortgage of $120,000 costing a monthly $564 (3.875% interest rate). In addition to the mortgage payment, you must also include Insurance and Property Taxes which come out to be $80 and $250 respectively. All in, your expenses would be $894. Assuming we use the 1% Rule of $1500 per month rent, your total income is $1500. By subtracting $894 from $1500, your total cash flow is $606 per month!
Home Price: $150,000
Mortgage: $120,000, financed at $564/mo with 3.875% interest
Taxes + Insurance: $330
Total Expenses: $894
Rental Income: $1500
Total Income: $1500
Net Cash Flow = $1500 - $894 = $606 / month
This is not an isolated nor out of reach example either. In fact, these are the average rental home purchases through Doorvest!
Equity Growth
Equity refers to the market value of your home less the amount you owe on a mortgage. Following our previous example, since the value of the home is $150,000 and the mortgage is $120,000, you own the difference in equity. So, you own $30,000 in equity.
Fair Market Value - Mortgage = Equity
$150,000 - $120,000 = $30,000
To fully understand this, you must know that a mortgage is primarily composed of two components: the cost of interest and the cost of the loan. The cost of interest is what you pay the bank to loan you money over a period of time. However, the cost of the loan is paying into your equity (or principal).
So let's follow our old example. In the beginning, we pay our mortgage loan at $564 per month. This broken down into $176.50 paid to principal and $387.50 paid to interest. So in this first month, you would gain $176.50 in equity making your total equity worth $30,176.50.
Current Equity + Amount Paid to Principal = New Equity
$30,000 + $176.50 = $30,176.50
*If you're paying attention, you might notice you pay over double in interest than in principal. This is because of a loan payment system called Amortization. Amortization is outside the scope of this guide. However, the idea is that you pay more interest in the beginning than at the end. So by the end of our above example, in the last month of your loan, you would pay $559.76 in principal and only $4.24 in interest.
Appreciation
As I said previously, real estate has the distinct ability to earn both income and appreciation jointly. Appreciation refers to the growth of the property's value over time with reliance on the market. Explained simply, if houses in your area become more in demand, their property value will increase due to limited supply.
Depending on a variety of factors, appreciation is variable — which means your property value may grow significantly over time or not grow at all. On average, home prices across the United States have increase year over year making it an attractive and relatively secure investment. Experts estimate a conservative 3% return on average, but this may vary depending on local markets.
For me to properly explain appreciation, I must first explain leverage.
Leverage
Leverage is one of the few tools not normally available for stocks and bonds. In simple terms, leverage is the ability to use borrowed money (e.g. your mortgage loan) to expand a person's asset base. This typically increases the potential return of the investment and amplifies returns.
In our example, the purchase price is $150,000 and the expected appreciation in the first year is $4,500, equal to 3% of the home value. That said, the investor’s initial investment (downpayment) is $30,000 and therefore the effective return due to appreciation is 15% ($4,500 appreciation / $30,000 initial investment). This is known as a levered return.
Because of leverage, you are able to earn multiple times of appreciation based on your initial investment of $30,000.
As with most investments, owning a rental home in the long term will take advantage of compounding. A $150,000 home is expected to have earned $214,089 in appreciation over a 30-year period assuming a conservative 3% annual growth rate.
Diversification
All investment portfolios are subject to risk. However, most successful investors reduce losses by allocating their portfolios across multiple markets.
Investing in only one market like stocks makes your portfolio subject to public market risk (the stock market). With the rise of Exchange Traded Funds (ETFs), these investments are becoming more correlated with one another making it difficult to use the stock market to properly diversify.
However, by investing in an additional market, like rental real estate, you are able to participate in a market that is not entirely related to the stock market that has a history of capturing long-term appreciation and income.
According to David Swensen, the Chief Investment Officer of the Yale Endowment, you should allocate upwards of 20% of an your entire investment portfolio toward alternative investments like real estate to maximize return potential and reduce portfolio risk.
To further discuss using real estate as a secure hedge to reduce risk, we must discuss another personal finance principle: liquidity.
Assets like stocks and bonds are said to have "high liquidity" because they can be sold on the stock market quickly. This makes them extremely flexible. However, the flipside is that this liquidity increases volatility meaning the value changes often.
Assets like rental real estate are said to have "low liquidity" because they require more time to be sold as there is more involved in the sale of real estate. While this may seem to be a negative, there is upside to owning a low liquid asset such as stability of price.
Conclusion
Let's recap.
Real estate investments offer a number of benefits not typically found in other investments. These include income from rental payments, appreciation in property value, and diversification. There's more — but we'll cover them in the subsequent chapters as they require more thought and explanation!
Because real estate is typically a long-term investment, it is important to choose the best options for you in your situation.