With 30-year mortgages and 27.5-year depreciation useful lives, real estate time frames can last for most of your life. For patient, long-term-oriented investors, that time can be spent building a true fortune.
The first step is coming up with an airtight, long-term strategy for investing. It can be adjusted over time, but the basics should remain the same.
For me, the two basic pieces that have led to success are not being afraid to use debt the right way and avoiding short-term purchases, better known as flips. Let's go over both of these pieces and discuss how I've incorporated them so you can potentially include them in your own real estate investing strategy.
Leverage is your friend
As long as interest rates are relatively low, leverage is what makes you rich in investing. Rent payments can add a little cash flow to your bank account each month. Rental property accounting can reduce your taxes, and sometimes you can sell a property for more than you paid. Leverage is what allows you to make five or six times what you invested over time.
Let's say you purchase a rental property for $400,000 with 10% down and a 6% interest rate. If the price of the property doubles over 10 years, that's capital appreciation of about 7.2% per year. Your actual cash-on-cash return is far higher.
You invested $40,000 to start and then paid the loan down about $60,000 over 10 years. That's a $100,000 investment over 10 years with a $500,000 payoff (the $800,000 sale price minus the $300,000 loan balance).
The next step is to not pay off mortgages early if the rate is low. The average stock market return over the long term is 10% or so. Real estate returns for enterprising investors can be even better. Any dollar that is used to pay down a mortgage with a 4% or even 6% rate is a dollar that can't be invested at a higher rate.
Finally, don't be afraid to re-lever houses where the mortgage has been paid off or paid down. A paid-off house is a big equity pool that can be used for the down payment on another place. Of course, if you're going to do this, keep the house updated and maintained so that you can sell it quickly in a worst-case scenario.
That said, taking on debt willy-nilly is not a great idea. You shouldn't overload on credit card debt or otherwise use debt to live beyond your means. When you can use debt to purchase an asset that will appreciate in value and provide consistent cash flow, it makes sense if the rate is lower than your expected return.
My wife and I have made good use of leverage in our own investing. Each of our rental properties was purchased as a residence with just 5% to 10% down. Later, we refinanced all three while simultaneously moving them into an LLC and taking out cash for operating expenses. Now there's a commercial loan on the property (with a very advantageous loan-to-value ratio), and we're protected from liability.
In the future, we will have plenty of ammo to use to buy more properties by restructuring this loan and taking cash out. We could even take cash out and distribute it to ourselves -- with no tax liability.
Skip the flip
Flipping is a popular real estate strategy among TV producers. It's less popular among seasoned real estate investors. While it can be successful while the market is soaring, it can quickly lead to big losses when the market turns.
For a flip to be successful, several unrelated parts need to work out for the investor. Market prices need to keep going up. Costs associated with construction needs to remain stable. Debt costs need to stay low. Demand needs to be there when the house is ready for sale. If any one of these factors doesn't work out, it could kill the whole deal.
If you pick a great house, fix it up quickly, and then demand dries up, you won't be able to sell it for what you expected, and you'll be stuck making mortgage payments. Or, if you find a house and know there's demand but once you can finally start fixing it up, lumber and steel prices are up 30%, it could kill your margin.
There's a saying in finance that everyone is a genius in a bull market. If population growth, low interest rates, and economy-wide inflation boosts an entire geographical market by 20% a year, most flippers will make a profit. And innate biases could convince them that they made a profit because they're good investors.
There's another related saying, typically attributed to Warren Buffett: "When the tide goes out, we find out who's been swimming naked." Investors who have benefited from sloppy flips with easy money will find profits far harder to come by when prices aren't moving in their favor.
I've personally had good luck with short-term price increases. The first investment property that I purchased back in 2015 recently appraised for more than double the purchase price. But I won't be selling it any time soon. It already produces cash flow each month, rent prices are going up, and I would have a ridiculous tax liability if I sold it now.
The root of both of these practices is patience. Here's why:
- To allow interest to keep accruing because you have better investment opportunities for your cash.
- To rent out properties even if the market has overheated and the potential sale price is high.
- Most of all, to invest in real estate even if it will take a while to pay off -- because after a lifetime, it certainly will.