Components of Real Estate Income

Real Estate investing
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Single family homes. Very popular real estate investment asset class.

Rental real estate is an asset class which only finds its way into peoples’ portfolios if they learn about it through their network. Traditional 401k / RRSP plans aren’t suitable for investing in real estate direct. There are of course indirect ways to invest in real estate in traditional investment accounts via Real Estate Investment Trusts. I tend to favour direct real estate investments which give me the deed of ownership over a property and complete control over its management as opposed to REITs. REITs are traded on a stock exchange and therefore their value is subject to demand factors which do not necessarily correlate to the value of the underlying properties. For example, in 2020, REITs that hold office properties lost incredible amounts of value, even though the rental income from the properties continued to flow at rates almost the same as before the pandemic. This loss in value is attributable to investor sentiment and the guessing game of how office properties’ use will change over time after the pandemic. When one owns the title to a real estate property, the value is far less volatile at any given time.

Based on lack of financial literacy training, real estate can have a reputation for low returns. A property’s income after expenses, divided by its value, is called its capitalization rate, or “Cap Rate”. If a property has a 5% cap rate, it sounds like a boring, fixed income investment that should really only be used by retirees who need a monthly income right? Wrong.

One of the main attractions for real estate investing is leverage. Leverage means that an investor can leverage other peoples’ money to buy an investment. Given the high absolute dollar value of real estate, in the vast majority of cases investors use financing to acquire the property. For the everyday investor looking to buy a single family home, duplex or condo, the financing usually comes from a bank. For commercial property investors who are acquiring properties in the $50 million and up range, financing is available from a variety of institutional investors like pension funds, insurance companies, REITs and mortgage funds.

What is the benefit of leverage?

When acquiring a property for rental income, the bank will typically offer financing up to 80% of the value of the property. Therefore, using round numbers, if you want to buy a property valued at $100,000, the bank will offer to lend you $80,000. That means that you, the investor, only need to invest $20,000 of your own money to acquire a $100,000 asset. If the asset goes up by 5%, all of those gains go to you as an investor, and leverage means that the $5,000 gain in the value of the property is not a 5% return, it is a 25% return on your investment. $5,000 divided by $20,000 is 25%!

Now, of course, banks need to make money as well, so they charge an interest rate on their loan. In today’s market, that interest rate is probably around 3%. They also make sure they are being paid back their loan amount through a process called amortization. Amortization means that over the life of the loan, an amount is paid back each year so that at the end o the amortization period (about 25-30 years), their original loan is totally paid off. A loan amortization schedule looks like the following:

Mortgage Amortization Schedule for a Real Estate Investment

As you can see above, in the first year on an $80,000 mortgage, the investor will have to pay the bank a total of $4,047.40. This includes both bank interest of $2,377.16 and repayment of principal of $1,670.24. By the end of the first year, the loan balance is down to $78,329.76.

Components of Real Estate Investment Returns

Clearly, there’s a lot more going on here than just the 5% income yield from the investment. Let’s break it down so its clear to understand.

Components of real estate income, broken down

So, starting with the 5% yield on the property’s value before leverage is factored in, $5,000 is produced by the tenants of the property. Then, we use that $5,000 to pay for the bank interest and principal repayment of $4,047. We are left with $953 of free cash flow from the property each year.

Now remember, the $4,047 includes principal repayment, which is reducing the loan and therefore increasing your equity in the property. Therefore, your equity of $20,000 you invested turns into $21,670.24 after the first year.

Next up is appreciation. Remember this all accrues to the property owner, not the bank. So that full $5,000 you made from the 5% appreciation goes right to you.

So in total, through cash flow, appreciation and principal reduction, your return on your $20,000 investment is $7,623, or 38% in a single year. Try earning that in an index fund!

Risks

Now, of course, higher returns usually mean higher risk of loss. This is true for real estate as well. The downside to leverage is that if the property stops producing income that can service the interest and principal payment requirements, the bank can foreclose on the property and sell it to get their money back. If this happens, all proceeds from the sale first go to the bank, and only if the sales price is sufficient to exceed the banks loan, do you as an investor get any of your equity back.

So how do you mitigate these risks? Firstly, you need to do due diligence. Do your homework on the property you are buying. You need to be an expert on rents to expect, costs associated with ownership, vacancy in the neighborhood and so forth so you know how much you can get from a rental, how easy it is to get a new tenant if your tenant leaves and how likely it is that you’ll have issues with income production.

You also want to always have a liquid source of funds that can step in and service the mortgage during vacancy periods. Maybe that’s money in an index fund that you can access easily. It’s always better to not have the bank foreclose! Some people call this the SWAN fund for “Sleep Well At Night”. In essence, don’t buy a property if you can’t afford to own it absent a tenant for a few months – tenants come and go.

A great way to mitigate vacancy risk is to invest into a multi-unit property. If you have 8-10 tenants in a property, it isn’t the end of the world if one leaves and needs to be replaced. This of course increases the dollar value o the property and therefore the equity required, so you may need to “syndicate” more equity from friends, family or investors. The same returns per dollar invested still exist, you just own less of the property and share the risks and rewards with others. There are other ways to invest in larger properties as well through sites like fundrise.com which takes investments from everyday investors into larger assets otherwise reserved for institutional investors – a really cool concept!

Tax Benefits

As a final benefit, real estate comes with special tax advantages as well like capital gains tax treatment and depreciation. There’s a reason why Donald Trump paid so little in taxes as a real estate investor – he wasn’t evading taxes, he was taking advantage of the incentives the government offers to real estate investors. This is because the government wants investors to build and invest in real estate so that there is an ample supply of homes, offices, warehouses and shopping to fuel the economy and create jobs.

Capital gains treatment is where the government allows investors to either include less of their gains on the sale of real estate in their income or they offer a lower tax rate overall on real estate income. In Canada, capital gains are included only 50% in income. In the US, capital gains on property sold more than a year after acquisition max out at 20%, and in many cases are less, as follows:

Long-term capital gains tax rates for the 2021 tax year

FILING STATUS0% RATE15% RATE20% RATE
SingleUp to $40,400$40,401 – $445,850Over $445,850
Married filing jointlyUp to $80,800$80,801 – $501,600Over $501,600
Married filing separatelyUp to $40,400$40,401 – $250,800Over $250,800
Head of householdUp to $54,100$54,101 – $473,750Over $473,750
IRS Long Term Capital Gains Tax rates

Depreciation is another government incentive. Depreciation is the ability for taxpayers to take a deduction on their tax return to reduce their taxable income and therefore their taxes. Depreciation is designed to mimic the “use of value” over time from a capital asset like a building. It’s only a few percent per year, but even a few per cent on an asset valued in the hundreds of thousands of dollars is a significant current tax deduction. Depreciation reduces your tax cost of the asset that is used later when you sell to determine your taxable gain, so you end up paying tax later. The time value of money from the tax savings is the main draw here.

Overall

I like real estate a lot because it’s tangible and easy to understand. People will always need properties to live, work and play in. Land is a scarce resource – as my dad always said, “They aren’t making any more of it”. Over time, the power of leverage and tax benefits can result in incredible returns. This is why real estate has created more millionaires than any other asset class. If you don’t own any investment real estate, I suggest you look into it. You might decide to move some of your capital from typical asset classes like stocks, ETFs, Mutual funds and bonds into real estate! As I think is clear from the above, real estate is NOT just for retirees!

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