Episode 13 – Ask Pancham #1
In today’s show, Pancham answers a question about real estate investing. Specifically, why does Pancham prefer investing in real estate? And, how is real estate investing different from REIT?
To answer this question, Pancham espouses on his “IDEAL” philosophy of investing. Tune in to learn why real estate is an IDEAL investment which can help you earn excellent returns without taking on unnecessary risk.
- 00:51 – Question of the day – Why do you like to invest in real estate? What are your reasons? How is it different from investing in REIT’s?
- 01:20 – Pancham explains why real estate is an IDEAL investment
- 02:48 – What are the expenses for a typical real estate investment?
- 04:17 – What is depreciation? And, how can it help you save your tax dollars?
- 07:38 – What is cost segregation?
- 08:00 – How can the buildup of equity increase your returns from a real estate property investment
- 09:08 – How appreciation can help you realize handsome returns from your real estate investment
- 10:40 – Understanding leverage, and how it can help you earn better returns
- 12:31 – Pros and Cons of investing in REIT’s
- 13:42 – Get access to lucrative real estate deals by becoming a part of the Gold Collar Investor Club
3 Key Points:
- Typical expenses for a real estate property
- How can depreciation help you save your tax dollars
- Pros and Cons of REIT investing
Get in Touch:
Welcome to the gold collar investor podcast show #13. This is Pancham. If this is your first time listening, then thanks for coming. The gold collar investor podcast is produced every week for your learning and enjoyment. Show notes can be found at thegoldcollarinvestor.com/show8. All links are in the show notes. Now, let’s get into the show.
This is a special show where I will be discussing questions from the listeners which can benefit a much wider audience. I will try to do this once every month or once every two months depending on the flow of the questions. Before we get into the show, I would like to remind you that you can get access to my free report on the Top 6 reasons on why you should diversify out of Wall-Street investments. You can go directly to the website www.thegoldcollarinvestor.com and download it for free.
Now, let’s go to the first question.
- Why do you like to invest in real estate? What are your reasons? Also, how is it different from investing in REITs?
First of all, thanks for submitting the question. It’s a great question which I have not explained in detailed in the past shows. These are two different questions and let me try to answer the first part i.e. my reasons to invest in real estate. Investing in real estate is a very general statement. Let’s make it more specific. I
specifically like to invest in income producing real estate or in other words cashflowing real
estate. I have narrowed down the reasons to an acronym called IDEAL. Yes, I.D.E.A.L.
I – Income
D – Depreciation
E – Equity
A – Appreciation
L – Leverage
Real estate is an IDEAL investment. Convenient isn’t it? 🙂 Let’s discuss this by walking through an example. Lets say we invest in house located at 123 Main St. Its in a great neighborhood and has the following attributes:
- 1,600 square feet
- 3 bedrooms and 2 bathrooms with a 2 car garage
- Fenced in backyard
- Purchase price: $100,000
- Rental price: $1,100
- Property taxes of $2000
- Insurance of $500
Very basic boilerplate property. You can find properties with those numbers in many markets even today. So let’s dive right in, shall we, and discuss exactly why investing in income producing rental property is so awesome!
I – Income
The “I” in IDEAL stands for income. You buy a house like 123 Main Lane, rent it for $1,100 and this rent covers your mortgage, your expenses like insurance, taxes, etc. Hopefully it then throws off a couple hundred dollars each month in cash.
For instance, in our example property, if you put in $20,000 as a down payment, got a loan for $80K from the bank, your mortgage payment will be something like $429 @ 5% and 30 years loan. You add insurance and taxes to it, it becomes about $640/month. Then you factor in maintenance, a management fee (even if you manage it, this should be figured in) – let’s say $100 per month for both of these, and maybe another $50 in expenses. So, that’s another $250 making it the total of $890 . Lets say its $900.
At the end of the month, your cash flow is 1100 income minus the 900 in expenses gives you about $200 per month or $2400 per year. Thats a 12% cash on cash return on your $20,000 deposit. I bet your bank doesn’t offer you that!
D – Depreciation
Now here’s where things get interesting. Depreciation occurs because IRS gives incentive to real estate investors to spread out most of the cost of real estate purchases over 27.5 years for residential properties. This creates an annual depreciation expense. But this type of expense isn’t something that comes out of your bank account like insurance or maintenance costs. It’s just a “paper” expense that shelters (i.e protects) your income from taxes each year. If you want to hear more on this, then listen to the show #4 by the CPA Brandon Hall on your biggest expense. So, let’s say that 123 Main St has a land value of $25K and the house itself is valued at $75K. So, if you were to depreciate 100$ over 27.5 year, you will get about 3.63$ per year. So, the straight line depreciation produces about 3.63% of paper loss every year.
Well, 3.63% of $75K is about $2,722 per year. That’s exactly what your write off is and you pay no taxes on that part.
Well, okay, the tax bill is going to be calculated on your taxable income. If you were thinking that the taxable income is going to be $2400 from the previous point we discussed under the I i.e. Income section, you will be almost correct. In order to calculate your taxable income, you will need to add back the principal part of your mortgage payment. Your mortgage payment consist of both principal and interest. In the earlier years, the principal is much smaller than the mortgage interest. In our example, its about $100 out of $430 per month. So, for tax purposes, lets add that $100 per month or 1200$ annually to your profit of $2400. It comes out to be $3600 of taxable income. Then you subtract the depreciation of $2,722 and your total taxable income comes out to be $878. Lets round it up to $900. Assuming that you are in 30% tax bracket, the tax liability is going to be $300. Your actual profit after the taxes in year 1 is going to be $2400 minus the tax bill of $300. That’s about 2100$ or 10.5%
You can reduce the tax even further with an advanced strategy call cost segregation where you breakdown the real property of 75000 into components. Like plumbing, wiring, furniture, carpet, etc. But we will leave that for some other day. Show# 4 by Brandon Hall goes into this topic. So, if you are interested, you can listen to that show.
E – Equity
If you use mortgage debt to purchase real estate AND if your rent pays all of your expenses, your tenant is essentially buying your house for you. As you probably already know, equity in a property is created when you pay down your mortgage. Each year that you own your property, you’re bringing down that $80K debt a little each year, and a little bit more each month.
This comes into play when you sell, because you’re going to recapture that equity in the form of cash. It works out to about 3% average each year that you are paying down. 3% of $80K is $2,400. This means that every year you own 123 Main St and you pay your mortgage, you’re making 12% on your original $20K.
Add that to the 10.5% in cash that you’re making and so far, your ROI (return on investment) is over 22%
A – Appreciation
The other way that 123 Main St can passively increase in value is through appreciation. Over the long run, real estate prices and rent tend to appreciate (i.e. increase in price) at the same rate as inflation (~2-3% per year). And while it might not sound like much, when combined with the other benefits and when compounded over long periods, appreciation can build enormous wealth. However, real estate is so local, it will depend on the local market where your property is located on how much it will actually go up in value.
So, for example, let’s say that you own 123 Main St for 5 years. You had bought it for $100K and let’s assume that the house is now valued at $110K. That is just 10% increase in price over 5 years. Reasonable enough right? Also, lets assume that you paid down 10K in loan over 5 years, leaving your debt at 70K. You now have $40K in equity which is a 100% profit on your original $20K! Thats 20% average year over year in 5 years. So, now your total profit is 22% + 20% which is equal to 42%!!! Are you convinced yet?
L – Leverage
Now here is where other people’s money really comes into play. Other people’s money in our case is a bank’s money. One of the best things about real estate investing over every other kind of investment is that you don’t need 100% cash to buy the asset. You can leverage other people’s money to purchase the asset. What’s even better than that is that while the bank, for instance, takes 80% of the risk – they get none of the return outside of their loan payments! You get 100% of the benefits of cash flow, tax breaks, equity buildup and appreciation. This magnifies all the other four benefits. And your money inflation protected as well.
How’s that for an awesome deal! So, you can see how real estate pays you in many different ways.
Granted it’s slow but its a sure and very less volatile way of creating wealth. Someone wise said that investing is like farming. Farmers sow the seeds and then watch them grow and become trees over the years. Investing is similar. You watch your investments grow over the years.
Now, lets get back to the second question. How is it different from buy REIT?
Its very different if you understand the first part of the answer. By investing in REITs, you would not get all of the above benefits of investing in real estate. You miss out depreciation and leverage part. Depending on how the REIT is structured, you may not get full benefit of income, equity and appreciation.
On the flip side, one benefit of investing in REIT is that its liquid and you can buy in small quantities. Some people say that they don’t like the prospect of finding, buying, managing the properties. I totally get that but there are other ways to get involved passively through syndications and reap all the above benefits of owning real estate. If you don’t know what that is, you can listen to the show#7 on Passive investing.
So, that is it. My conclusion is that real estate investing should be one of the pillars of your overall investing strategy. You do not have to be an active investor to invest in real estate. If you are an accredited investor, you can become part of the gold collar investor club by signing up on thegoldcollarinvestor.com/club. I will be putting together investing opportunities exclusively for this group. These are the opportunities where I have done my part of the due diligence and will be investing my own money alongside you. So, I will see you in the club.
This is a second Ask Pancham show. This is where I discuss questions from the listeners. I am going to do this once every 4 to 6 weeks depending on the flow of questions. Before we get into the show, I would like to remind you that you can get access to my free report on the Top 6 reasons on why you should diversify out of Wall-Street investments. You can directly go to the website www.thegoldcollarinvestor.com and download it for free.