There are several advantages to invest in real estate over other investment vehicles.
Leverage is simply the extent to which debt is used to finance real estate. Successful real estate investors optimize (not maximize!) their leverage. The general rule is “Borrow to buy, sell for cash.” More leverage can make a good investment a great investment. Wise real estate investors generally look for those properties that provide the most financing.
To optimize leverage, many investors have a specific strategy that they use in identifying investment opportunities. This involves acquisition strategies that minimize the cash necessary to get into a project and divestiture strategies that look to all cash exits.
Operating leverage is a characteristic commonly found in real estate properties due to its large proportion of fixed cost to total costs. This characteristic can be described in terms of the relationship between sales volume and profitability of a piece of property. Commercial real estate generally has a large degree of operating leverage due to its fixed costs.
When fixed costs are large relative to variable costs, then small increases in sales will generate large increases in profits. The other side of the coin is that large fixed costs require a substantial volume of sales to break even.
Real estate values tend to rise with inflation. In fact, much real estate often rises faster than inflation because it is in relative limited supply compared to other consumer goods and services. Because real estate supply tends to be inelastic (insensitive to prices), as demand increases prices will rise faster in this sector.
Of course, a word of caution is necessary. Much depends on location and the demand for property at that location. Great care must be exercised in the selection of specific commercial real estate opportunities.
Two important advantages come into play here. The first is interest costs. Interest costs can be fully tax deductible for your personal residence (up to a limit) or for any commercial real estate investment. This means the cost of funds is reduced by your marginal tax rate.
The second important tax advantage to owning real estate is the ability to depreciate any property being rented. Depreciation is a legitimate (non cash) deduction used to offset revenue that would otherwise be subject to taxes. This means you can show a loss on your real estate investment, use that loss to reduce your personal income, and thus lower your taxes.
Investing in Real Estate Is Like Owning Your Own Business
Many individuals want to gain more “control” over their lives. It is not uncommon for such individuals to want to “start their own business” to gain more control over their lives. Commercial real estate is an activity you control entirely. You find the opportunities, arrange the financing, bring all the elements together, and create something where there was nothing before.
An individual can enter this business starting small and staying small, with the real estate investing being a profitable hobby. As an alternative, an investor can start small and over time, with a few good moves, grow his or her business into a high-paying full-time job.
Debt in an Inflationary World Is Good
Commercial real estate investors are debtors. They borrow money now to pay it back later. In an inflationary environment this confers a tremendous advantage to the buyer. In theory, interest rates adjust for the level of inflation by adding an inflation premium to the real rate of interest. In the real world, this adjustment process appears slow and uncertain.
There have been a number of times within the past two decades where the rate of inflation exceeded the nominal rate of interest. The effects of inflation are so powerful and pervasive that economists see inflation as a primary factor in redistributing wealth in our society. The real question is which side of this transfer will you be on?
Compounding Cash Flows
A hallmark of commercial real estate investment is that such investments yield compounding cash flows. Taking advantage of this requires a fairly long-term horizon, but that gets back to the tortoise and hare metaphor. An individual can put $10,000 down on a well-located duplex apartment that will earn 21% annually over the next 15 years with very little risk. It takes a long time, but the $10,000 turns into $174,494!
This is the miracle of compound interest. In finance, the tortoise not only finishes the race, the tortoise wins the race too! Rabbits show a burst of speed that looks good for a short time, but they rarely finish the race and almost never win the race. Compounding cash flows are the surest way to wealth creation.
Social policy in the United States encourages home ownership. This has resulted in financial and banking policies that make acquiring a home relatively easy. This happens because houses can be bought for very little cash up front and interest payments are subsidized by making them deductible against earned income. Even a person with very little income can enjoy the benefits of financial leverage.
The really good news is that much of these benefits can apply to the purchase of a second (vacation) home. This is a great path to becoming a successful real estate investor. Mortgage interest on a second home may be deductible if the mortgage does not exceed the fair market value of the home and the mortgages on both your primary residence and the second home do not exceed $1 million.