The Impact of Real Estate as a Business in order to decrease Economic Inequality

It is no secret that the majority of millionaires and high net worth individuals consider real estate critical to wealth building. These individuals typically allocate >60% of their assets towards a business that can be in the form of real estate. Portfolio allocation is important when thinking about risk mitigation and achieving an outsized risk-adjusted return in the long run. Personally, my investment allocation consists of 55% towards some form of real estate with the other 45% in public equities. A further breakdown of the real estate portfolio is 40% single-family homes and 60% commercial properties ranging from several apartment buildings and office space to a health care building and self-storage facilities. With a massive disparity in homeownership by race. I thought it was important to highlight the importance of homeownership as a form of investment and its crucial role in wealth generation when considered in the context of a business. I will also highlight how such an asset class can lead to financial independence sooner rather than later when you factor in the cash flow that is generated from rental activities yearly.

This blog post is something I am passionate about. One of the few ways to reduce the economic disparity shown in the table below is to encourage and motivate the disenfranchised to take on business ownership in the real estate industry as it will be a source that can ultimately narrow the gap on the inequalities we see today in society. 

Benefits of having Real Estate as a Business

1. Near Term Cash Flow Generation

The benefit of real estate as a business that can be felt from day 1 is the in-place cash flow generation. Without including any other benefits, it is not unrealistic to achieve a 10-15% return on a rental property simply through the rental cash flow. This beats the average stock market return of the S&P500.

2. Appreciation and Forced Appreciation

Forced appreciation involves purchasing a property at a discount. The real estate market is not as efficient as the stock market because of its illiquid nature and we do not have automated systems that trade homes. There is a multitude of scenarios why a seller might decide to put their property on the market (e.g. divorce, retiring, down-sizing, medical emergency, e.t.c). Due to this, it is very realistic to get a "steal" in the current market if one looks hard enough. Also, the average home in the US has appreciated about 4% annually and this adds to the overall return of the property when it is sold.

3. Tax Benefits

For high-income earners, using real estate as a business can considerably lower the amount of taxes an individual is liable for. On paper, the real estate business can show as a loss but in reality, it was a large gain in that particular year. The most important tax benefit is depreciation. Since real estate is a tangible asset that can be depreciated each year, it should be an investor's best friend. It is important to keep the depreciation recapture tax rate in mind on the sale, however. Other tax benefits are the ability to deduct the interest payments, property taxes, repairs, utilities, home office, mileage driven, and all capital expenses for the business from your taxable income. 

A rough rule of thumb is a 3% mortgage interest rate is effectively 2% when only the mortgage interest payments tax benefit for an individual in the 35% tax bracket is factored in. 

4. Outsized Risk-Adjusted Returns

When you factor in the performance of real estate as a hard-asset, leverage, and the principal paydown by the renters, real estate as an asset class is able to achieve returns that are unheard of on your invested capital.

5. Portfolio Diversification

When thinking about asset allocation, it is wise to consider real estate as a portion of one's portfolio due to its lack of correlation to the stock market. As an example, suppose one owns a real estate property that is generating positive cash flow in a relatively good market. When we have a market meltdown in the stock market, the cash flows from the rental property are unaffected because the renter is still on the lease and people will always need a place to live. This powerful scenario shows why real estate is critical to portfolio diversification. Asset allocation changes with age and should be modified based on the goals of each investor.

6. Passive Equity Build-Up

My personal favorite when it comes to real estate investing is passive equity build-up. The rent charged to a renter covers all the expenses including the principal of the mortgage. Over 30-years of debt financing, the loan-to-value (LTV) goes to zero from 80% in year 1. If this property was managed properly and the property was located in a high appreciation area, the equity built up over those 30 years can be huge which significantly boosts the return of the investment. An illustration of the equity build-up portion of an investment is shown below.

7. Leverage

Real estate has the advantage of using leverage to boost returns (similar to using margins in stock purchases). Simply put, leverage is the capacity to invest someone else's money in a project and share a portion of the profits. This can help minimize the amount of up-front capital required by a real estate investor. One can participate as a General Partner (GP) or a Limited Partner (LP) or both. Purchasing a rental property, financing 80% of the home value, and fully managing the property while keeping all the excess profits less the interest payments is a simple example of the use of Leverage. The bank is not entitled to any of the profits outside of the debt interest payment obligation. It is not uncommon to use leverage to boost the 1st year cash-on-cash return on a cash-flowing rental property by 2x simply by using leverage.

8. Hedge Against Inflation

The Federal Reserve recently announced that it will allow inflation to freely increase until it achieves an average inflation rate above 2%. With this, we would expect the prices of goods and services to increase on average by that amount. Since real estate is an appreciating asset, the prices of homes will benefit from this policy. Adding to the economic viability of real estate and minimizing the interest rate risk, the Fed pledged to keep interest rates low (thereby minimizing the cost of borrowing) in the foreseeable future until it sees a reason to adjust. 

How to Analyze a Real Estate Deal

The first thing to consider when analyzing a deal is "what will its cash flow be within the first year of purchase?" To calculate this value, you compute the yearly rental income minus the cost of borrowing, insurance, property taxes, repairs, vacancy, and utilities. You then take this cash flow and divide by the initial capital contributed to purchase the property. Although the returns in real estate have come considerably down since the great recession in 2008/2009, it is not uncommon to achieve 10-20% cash-on-cash returns for solid rental properties. As an example, my debt-financed single-family rentals have averaged between 13-14% cash-on-cash return. The cash-on-cash return will increase through time due to the usual yearly rent increases.

The next thing to do is to factor in appreciation. The national average appreciation rate in the US is about 4% but this number can vary widely based on the location of the property. Some properties can appreciate at a 10% rate while some can remain flat or even decline in value if the economy struggles in that area. To compute the home value, you simply take the current value and escalate by the appreciation rate each year.

Finally, the last thing is to bring in the idea of principal paydown. As you own a rental, the mortgage is being paid for by the renters. This automatically increases your equity in the property and this value can be computed using the mortgage balance and home value at any point in time.

My recent purchases have targeted a year 1 cash-on-cash return of 12-15% and a home value appreciation of 5-9% excluding any forced appreciation on the "buy".

Pitfalls in Real Estate Investing

Since any form of business is not all rosy and it takes some sweat equity to run a successful business, below are some common pitfalls when it comes to investing in real estate.

1. Location, Location, Location is the most important factor to consider when purchasing a property. I wrote extensively on the best locations to purchase a home in the United States. A real estate purchase can easily under-perform in a difficult, cyclical location. What you want is a steady, straight smooth line growing area to purchase a property.

2. The next pitfall is purchasing a property with a lot of major repairs without getting a discounted value on the home. This can be a money sink very quickly. A way to minimize or eliminate the risk to have proper inspections done and also asking for a home warranty purchased by the seller for the first year and then evaluating its need in subsequent years. The warranty will reduce the cost of repairs for major appliances in the home.

3. A pitfall for those who participate in real estate through syndications is not properly researching the General Partner. You want a competent General Partner with a solid track record.

4. Another pitfall is partaking in the wrong sub-sector within the real estate asset class. It is no secret that retail industries have struggled over the past couple of years and will probably continue to struggle in the foreseeable future as we move to a more digital world. Due to this factor, investing in retail might not be recommended as the risk-adjusted returns would not compete with other asset classes.

5. The last pitfall is not properly accounting for the variables that go into computing the overall return of the property. If a deal is under-written optimistically, it can lead to realizing returns much lower and large opportunity cost when it is all said and done.

With the technological improvements within the real estate industry, I would be interested in seeing future progress made in cutting the transaction costs within this space. This will ultimately make real estate less illiquid and minimize the cost of capital thereby boosting returns. 

Financial Savant was born in 2018 and has received a really good reception so far. This blog serves as a resource to help spur open discussions on generating income, saving, investing, and overall wealth management.

Every article written on Financial Savant is based on first-hand experience and pertain to ongoing current events within the financial and economic-sphere.

Financial Savant recommends investing in real estate through a hands-off approach using Fundrise and managing your finances using Personal Capital.

For a detailed discussion of my favorite financial tools which I typically use weekly, you can visit the sidebar on the homepage. I have thoroughly researched all the products and use them personally. I have cut through the clutter so you do not have to. Financial Savant is glad to be a part of the #FIRE movement as we strive to achieve financial independence opening up a world of possibilities while creating generational wealth.


Recent Posts