Real estate has time and time again proven to be an outstanding investment. Whether you already invested in real estate or would like to in the future, we compiled some of the tremendous benefits to investing in real estate. So without further delay, here are the top 5 reasons why we think real estate should be part of your overall investment portfolio.
1. Tax Advantages
It’s no secret that tax laws in the US are inconsistent, and part of that inconsistency is their favoring of some investment options over others. Real estate is favored and can be especially advantageous. Depending on your unique situation, real estate tax laws can drastically benefit you in several ways. We can’t cover everything here, but some of the more prominent tax advantages to real estate include:
The IRS allows certain expenses to be considered tax-deductible. In short, a tax deduction permits you to lower your tax liability by reducing your taxable income. You can deduct things like property tax, insurance, management fees, advertising expenses, and mortgage interest, to name a few.
Avoiding Income Tax
If you choose to sell your appreciated real estate investment, the profits will either be taxed as short-term or long-term capital gains. In general, capital gains are taxed at a much lower rate than other types of income. That can always change if new laws are voted in, but generally speaking, capital gains are taxed at lower rates. The actual capital gains tax rate entirely depends on how long you’ve owned the property as well as your tax bracket. You can typically expect to pay anywhere from 0% to 37% - again, depending on your unique circumstances.
If you ever want to sell your investment property, look at section 1031 of the internal revenue code. This code section allows what is commonly known as a 1031 exchange, whereby real estate investors can defer capital gains well into the future. It essentially allows you to “swap” one investment property for another without paying taxes. There are few requirements for a 1031 exchange to be considered legitimate, but it is generally straightforward. It is a great way to increase the value of your real estate investment – all while avoiding taxes on the sale of your investment.
Depreciation is a bit of a weird concept. It is assumed that all “capital” assets, like machines, decrease in value over time and eventually become worthless. Depreciation is the process by which you are allowed to deduct, each year, a portion of the cost of the asset to reflect the fact that it is decreasing in value. Most of us can think of a piece of equipment or a truck that we know has decreased in value over time. So depreciation makes sense.
But real estate generally increases in value. The tax code assumes that ALL capital assets depreciate, and it considers real estate investment as a capital asset. So even though you may see your actual value increase over time, you will be able to deduct a portion of the original cost each year as depreciation.
Typically, real estate is assumed to decrease over 27.5 years, and you get to deduct this depreciation expense over that period. Using a quick example, say you purchase a property for $400,000, but you allocate $300,000 of the acquisition cost to the building and improvement (you cannot depreciate the land value). In this example, you would be allowed to deduct $10,909 ($300,000/27.5) a year as a qualified tax expense. You can leverage this to offset the income generated from the property.
2. Cash Flow / Passive Income
Investing in Real Estate is an excellent way to generate consistent cash flow. Cash flow is the money collected from rent less the expenses you incur from your rental property. This additional source of income is great and allows you maximum control of how you want to spend or save your newly found revenue stream. You can reinvest that money in other properties or use it to fund your lifestyle or retirement savings. The beauty of this is that the choice is yours to make.
The money you earn from your real estate investment is generally considered passive income. Passive income is any profit that requires minimal labor or effort to acquire. Passive income is one of the main reasons why people choose to invest in real estate in the first place. It allows you to earn income without having to quit your 9-to-5 job. However, to ensure that your real estate is passive on your part, you need a partner who will take on the day-to-day responsibilities of managing the property. If you don’t use a partner, like a property management company, your income is still considered “passive” for tax purposes, but you will have to put in the time and effort to manage it yourself.
Partner with a Property Management Company
Partnering with a property management company usually makes all the sense in the world. The property management company specializes in managing properties. Can you learn how to do this yourself? Yeah, you can. But often, you’ll be miles ahead by allowing them to do this for a modest fee.
A property management company has years of experience doing this. They know the tricks of the trade, ways to save time, decrease expenses, etc. They already know who the best electrician is, best handyman, and they’re willing to take that inevitable 11 PM call that the toilet isn’t working.
They will also provide the accounting for your rental unit(s) beyond the experience and the day-to-day grind they alleviate. Property managers will collect the rents – even from those tenants who fall behind. They will evict those tenants when necessary and handle all the paperwork. They will pay the vendors – the electricians, handymen, taxes, etc. And at the end of the month, they will give you a profit and loss statement showing you what you’ve earned. No muss, no fuss.
The list of benefits is extensive, but in our opinion, the best advantage of utilizing a property management company is to minimize vacancy. No investment is perfect, and vacancy can be a concern in real estate. However, with the expertise and resources that property management companies have, they can dramatically reduce the likelihood that your rental property will stay vacant for long. That allows you to mitigate the risk of having negative cash flow and enables you to maximize your rental income.
For all these reasons, we highly recommend that you hire a property management company.
3. Protection Against Inflation
Inflation is a silent killer, and it can completely derail your portfolio if you are not careful. Real estate provides a unique way to hedge against inflation. When inflation increases, so does the value of your investment. Over the long-term, your rental income increases too. As a rough rule of thumb, when inflation increases, so does your cash flow. The reason your cash flow generally increases is that two of your major expenses typically increase by less than inflation – or don’t increase at all.
If you mortgage your real estate, we recommend getting as long a fixed-rate loan as you can. A fixed-rate means that the mortgage payment won’t increase. Accordingly, when inflation hits, your rents go up, some of your expenses go up, but your mortgage stays the same. Your profit starts to grow over time. Additionally, in some states (like CA), the property tax increase is restricted. It can only increase per year by a set amount which is almost always less than the inflation rate.
Finally, as mentioned above, the value of your property tends to increase with inflation. That is one – but not the only – reason your value will appreciate over time.
Appreciation is the increase in value of your investment over time. Real estate will tend to appreciate by at least the rate of inflation, and generally by an additional amount which reflects the demand for property. Not all investments appreciate at the same rate, and you need to be careful to understand the value of your property’s type and location.
Real estate has a good track record over the long term (see below), but even over the last 13 years (since 2008), home prices in southern California have increased by 84%.
Here’s a quick table showing the comparative return rates for real estate (Vanguard Real Estate Index - VTI) vs. the S&P 500 over various periods from 2010 until 2020:
Notice that sometimes, real estate beat the S&P 500, but in others, it lagged. The point here is not to conclude that one is better than the other; to do that, you’d have to know the period to use going forward. Are you going to hold the real estate for just one year, five years, or twenty-five years? You’d have to then know in advance whether real estate or the S&P 500 is going to do better over that exact period of years.
That’s impossible to know. The point of this is to show that both investments are promising investments over the long term. Furthermore, there are substantial diversification benefits to real estate, even if the returns were the same.
Have you ever heard the phrase “don’t put all your eggs in one basket”? Well, that’s what diversification means. Diversification is the act of allocating your investments across various asset types. It is the key to mitigating risk in any investment portfolio. The reason is that different asset types typically go up and down at various times. It means that the gains in one offset the losses in another, and the entire portfolio doesn’t experience as much volatility.
Even if the average return is the same, your portfolio will be less volatile if the assets can offset one another. Here’s an example.
|Asset A||Asset B||50% Combo of A&B|
In our illustrative example, asset A has some good years and some terrible years. The average return is 10%, but there is lots of volatility. Asset B has the same volatility – just in opposite years – and has the same average.
Notice that the perfect combination of A & B generates an average return of 10%, but there is no volatility. That is an extreme example to illustrate the point, but the concept is accurate. Mixing asset categories that behave differently will reduce volatility, even if the average returns are the same.
If you already invested in stock, bonds, and other securities, you may consider yourself properly diversified. We don’t believe that is true. Yes, you are somewhat diversified because bonds and stocks behave differently, but real estate offers a third way to diversify and thus can reduce volatility even more.