The Four Levers of Real Estate Investing

I first became acquainted with real estate as an investment class when I became frustrated with the lack of control and understanding about my stock market investments. At the time, I had absolutely zero knowledge about any general or technical concepts regarding real estate. I probably couldn't have even told you what a mortgage was, and that's important to note because despite those things, I still understood how I could make money with real estate.

It began with the concept of buying the property and renting it out for more than it cost me to hold the property. It's an extremely simple concept to understand, but contained in that simple concept are what I like to refer to as the four "levers" of real estate. I believe I read the term "lever" somewhere else so I didn't come up with it, but it has always stuck with me because I like the visual. Let's start with the first one: appreciation.

Appreciation is just the rise in the value of the asset. So if I bought a house for $100,000 and 5 years later I sold it for $125,000, it appreciated by $25,000. This concept is the primary strategy people use when they invest in the stock market. They strive to "buy low and sell high" which is to say that they expect the price of their stock to appreciate. For what it's worth, I consider appreciation to be the LEAST important lever and the one I pay little attention to for one primary reason: I can't control it. In terms of a single family house, the value of that house is influenced by comparable houses selling in the area, as well as the general economic climate. If people aren't buying houses at the time I want to sell it, the price at which I can sell the house is naturally going to be lower. I consider appreciation to be the cherry on top of my real estate sundae. However, if appreciation does happen, its effect on my equity is magnified by the downward pull on the next lever: leverage or debt paydown.

A huge benefit to buying real estate is that you can pay as little as 20% of the purchase price (for purposes of this discussion, we'll disregard ways you can put down less than that) and still own and control 100% of the asset. It is possible to do this in the stock market by trading on margin, but to say the least, this is not an option available to most people. In real estate, in the example of that same $100,000 house from above, I would only have to pay $20,000 to own that house. The bank will give me a loan for that other $80,000. Aside from the obvious benefit of not having to come up with as much money, let's look at the end result and work our way back to see why this is so great.

If you paid $100,000 cash for the house, and sold it for $125,000, after selling costs you would have made roughly $15,000. Making 15% over 5 years isn't that exciting is it? But consider the return if you used leverage and only put $20,000 down. You would still be making roughly $15,000 from the sale, but instead of evaluating that against an investment of $100,000, you're comparing it against the $20,000 you put down, which is good for a 75% return.

Now to use a tired old phrase - but wait, there's more! Assuming you rented the property out after you bought it, and assuming you had made a good investment whose monthly rent covered your expenses, the tenant would have paid down your loan balance over those 5 years. So with an original loan amount of $80,000, you would owe roughly $72,000. So to get your final return, it would be (Sale Price - Selling Costs - Principal Balance - Down Payment = Total Proceeds), which, in this simple example comes out to about $23,000 which is a 115% return on your original investment of $20,000.

As you can see, leverage is a very powerful lever that can really magnify your returns. Like I said, this option is simply not available to most people in the stock market without trading on margin. It should be noted that trading on margin in a downside scenario can result in losses far greater than your original investment. The downside scenario for real estate is generally limited to your original investment in that property.

The third lever you can pull on with real estate is cash flow. This can be likened to a dividend on a stock. After all monthly expenses such as taxes, insurance, maintenance and repair reserves, and your mortgage payment are paid for by the rent, you should have some cash left over. It may only be $100 or so, but over the course of the year that's $1,200, and in our example above when we sold after year 5, that's another $6,000 on top of your return from the first two levers, further amplifying your return on investment.

Finally we have our fourth and my personal favorite lever: depreciation. You might be thinking that if depreciation is the opposite of appreciation, how is that a good thing? As far as the IRS is concerned, real property such as houses and apartments have a useful life of 27.5 years. The idea is that over time, through natural wear and tear, that piece of property becomes worth less and less, so you as the owner are able to count depreciation as an annual expense on paper, which in turn lowers your taxable basis. The annual expense you're allowed to deduct is calculated by taking the price you paid for the property, subtracting out the cost of the land (because dirt doesn't depreciate), and dividing the result by 27.5. So let's say from our example above that the land is valued at $25,000. That would mean that our annual depreciation is $100,000 - $25,000 = $75,000/27.5 = $2,727. So that means that if our cash flow was $1,200, we can subtract out an additional $2,727 of expense for depreciation, which leaves us with a result of -$1,527.

So as far as the IRS is concerned for tax reporting purposes, we lost $1,527. Of course, we didn't actually lose that money, we made $1,200. But because of that depreciation expense, it isn't taxable.

Now imagine if you spread the above example out across 4 properties. You could control $400,000 of real estate with only $80,000, but you still get to keep 100% of the upside from the four levers listed above. Sure, I may be biased after spending so much time working with real estate. But I simply don't see anything else like this that is readily available to the average person.

As it relates to baseball players, tax considerations are obviously important as you start making more money, so owning real estate is a way to improve your tax situation. But even before you start making a lot of money, due to the rollercoaster nature of careers and poor minor league pay, it's important to add cash FLOW to the top of your list of things to try to capture.

We're currently working on a guide to give you ideas and ways to build up your cash flow depending on where you are in your career, so stay tuned! As always, feel free to contact me using the Contact Us button above if you want to go over your current situation, or fill out our Invest With Us form if you want to discuss getting started in multifamily!